EMD: Finding Fundamental Value Through the Storm
Emerging markets (EM) debt has suffered alongside the rest of the global markets in recent weeks as credit spreads have widened past levels experienced during periods of volatility in 2016 and 2018, and in some cases, to levels not witnessed since the global financial crisis. The fall has been rapid, and perhaps unsurprisingly, commodity-producing countries and their currencies have been hardest hit, with several dropping ~20% from the end of January. The speed and severity of the fall have impacted both the fundamental and technical picture for EM debt. Specifically, from a technical standpoint:
Outflows: The asset class has experienced severe outflows in recent weeks, with redemptions now over $17 billion year to date. In the most recent weekly data from J.P. Morgan, retail funds experienced a record outflow of -$14.6 billion through March 19. Hard currency assets were the main source, with -$10.4 billion in redemptions, as the dollar has been in particularly high demand given investors’/traders’ liquidity needs vs. local currency assets (-$4.2 billion).
Liquidity: Outflows have exacerbated the currently challenged liquidity conditions. Price discovery has operated poorly in recent weeks as bid-ask spreads have widened and—based on the experience of our own trading desk—dealers have offered inconsistent pricing on the same or similar bonds. This has made it more difficult to transact, but also would suggest that investors may be unduly punished for selling in the current environment. It is also worth noting that some of the selling in the market is related to mandated de-risking, a result of regulatory risk management tools.
From a fundamental standpoint, the picture is more nuanced. While the world has changed drastically in just a few weeks, there are reasons to believe market prices may have overreacted.
COVID-19
While this crisis should not be taken lightly—especially given the tragic toll it is taking on humanity—recent statistics, as well as our own analysis, suggest that social-distancing initiatives in China, Japan and South Korea have helped bring the spread of the virus under control in those regions.
Additionally, conditions appear to have either improved materially (China) or been headed off relatively effectively (Korea and Japan). These trends and data suggest that the pandemic could come to an end more quickly than what some (especially Westerners) may be forecasting. If it turns out to be mainly a 2020 event, with only limited economic disruption in 2021 and beyond, that would support the contention that current prices appear significantly oversold.
