EMD: Increasingly constructive outlook means recent outperformance could continue
Despite the strong performance of emerging markets debt (EMD) so far this year, the outlook for the asset class is becoming increasingly constructive, suggesting EMD could continue to outperform. We’re cognisant of the risks, moments of volatility and potential for turns of sentiment that remain, but we would seek to be buyers on market hiccups as a function of our constructive view. There are a number of reasons underpinning this optimistic view on the asset class, which we set out below.
Recent returns for some sectors of EMD have been stellar, up in the low double digits. Globally important factors and events—G-3 central bank dovishness, a commodity market rebound, and China stimulus—have had an important bearing on performance. Country-specific developments have also had a significant impact: market-friendly political change in Argentina, presidential impeachment and hopes for real economic reform in Brazil, a sharp reduction in Russian geopolitical noise, and worsening political developments in both Turkey and South Africa.
There are a number of positive factors aligning in favour of the asset class. This is not to say the path ahead will be smooth and uneventful. Headwinds remain on the horizon. But if anything, these headwinds may provide opportunity to buy on the dips.
Some of the reasons for a constructive outlook on EMD include:
- Fundamentally, EM economies are in better shape, having undergone a considerable external adjustment over the last few years. Following a dip in the first quarter, growth across emerging markets has started to stabilise and gradually recover. This recovery has been driven principally by positive growth momentum in Latin America and Europe, albeit from a low base. The growth outlook for emerging markets should remain favourable over the coming quarters, supported by improved commodity price dynamics and encouraging political trends in Latin America in particular.
- The picture for developed markets, meanwhile, is less encouraging, with these economies inhibited by sluggish growth conditions and still-elevated government debt levels. This divergent growth picture should result in a moderate widening of what we term the EM “growth alpha”—the growth pick-up for emerging markets over developed markets—in excess of 2%. Historically, a wider growth alpha has tended to support capital flows into emerging markets, benefitting asset prices and currencies in the process.
- We’ve seen significant improvement in current accounts across emerging markets, with many now pushing towards surplus and fewer posting deficits in excess of 3%. Add to this the stabilisation and improvement in commodity prices and the terms of trade deterioration that has afflicted EMEA and Latin American economies should exhibit more positive reversal this year. Taken together, these greatly improved external metrics should support a recovery in EM net capital flows.
- From a bottom-up perspective in the corporate sector, we also strike a marginally more positive tone. EM corporates have reacted proactively and prudently in the face of a deteriorating environment by slashing capex, reducing dividends and using the proceeds to purchase their debt.
- Relative to global fixed income markets, EM debt looks attractively priced. Compared to both US Treasuries and inflation, EM local rates offer value, and against global government bonds, EM local yields are trading at the wider end of historical ranges.
- EM debt offers considerable opportunity for yield pick-up in an increasingly low-yielding world where close to USD 12 trillion of government debt outstanding is priced with negative yields. EM debt remains poised to attract further inflows in this global grab for yield.
- Factors of demand and supply are supportive. Investors continue to add back exposure to EM debt, while EM sovereign (ex. Gulf states and Argentina) and corporate issuance levels should be favourable to year end. The ever-expanding universe of negative- and low-yielding government debt globally should push an increasing number of non-dedicated EM debt investors into the asset class. Furthermore, the improving relative fundamental picture outlined above should also support portfolio flows to emerging markets as investors seek to gain exposure to the relatively stronger growth dynamics.
Of course there are still potential headwinds that could affect the asset class over the coming quarters, in particular global growth and recession risks, political pressure points and China-related volatility. But we would use any episodes of market weakness as an opportunity to add exposure.
EMD investors would be wise to focus on quality assets: those with stronger credit metrics and a more favourable risk profile. We believe these are the very first assets that will be targeted by global investors when seeking yield and exposure to EM debt.
Idiosyncratic stories whose risks are less correlated to global systematic risks also look interesting. Examples include Argentina sovereign credit, where valuations remain attractive and the prudent fiscal and monetary policy management evident since President Macri’s election seems likely to continue. Brazil corporate credit and local currency rates, where Dilma Rousseff’s impeachment has led to an improving macroeconomic story and the prospect of much-needed fiscal reform, while declining inflation pressure has created greater scope for the central bank to cut its benchmark rate.
Pierre-Yves Bareau is chief investment officer, Emerging Markets Debt, JP Morgan Asset Management