Emerging markets (EM) local currency denominated debt may be poised to outperform.
EMD performance was strong across the board in 2019, and the fourth quarter was no exception. It’s perhaps no surprise that sovereign hard-currency denominated bonds were the star performers throughout much of the year—typically viewed as somewhat lower-risk than their local-currency denominated counterparts, the asset class benefited from higher duration in a year when rates largely trended downward.
Toward year-end, this trend began to reverse. And while attractive opportunities remain across the sovereign hard-currency universe—particularly in countries like Brazil, where credit risk appears to be overpriced—attractive value has also emerged elsewhere.
In the fourth quarter, EM local currency bonds (5.2%) were the standout, outperforming both sovereign debt (1.81%) and corporate debt (2.2%).1 There are a few factors that may have contributed to this. Following the global financial crisis, the economy went through a massive deleveraging that resulted in an exodus out of riskier assets, EMs chief among them. Because of these outflows, EMs have been running smaller account deficits over time. As a result, the financing needs of EMs have come down over the last decade—meaning their balance sheets are in much better shape today. The headwinds faced by EMs have also battered their currencies and, based on measures that consider currencies’ real effective exchange rates relative to their terms of trade, EM currencies are now trading close to their cheapest levels in a decade.
EM Currencies Trade Near Cheapest Levels in Last Decade (Real Effective Exchange Rate/Terms of Trade)
Source: Haver Analytics. As of September 30, 2019.
The alignment of these factors suggests that the stage may now be set for the decade-old aversion to risk to begin to reverse course in 2020—paving the way for EM currencies to outperform, and potentially driving strength in EM local debt.
Another area that remains attractive is EM corporate debt, which has one of the highest Sharpe ratios of any major asset class over the last decade. Fundamentals remain stable, with many companies exhibiting positive revenue and EBITDA growth in recent years. Balance sheets have remained healthy and default rates have stayed low.
Drilling down, short-duration high yield debt looks particularly attractive, and its lower interest rate sensitivity could prove valuable if global economic conditions improve this year. Given the various idiosyncratic risk flare-ups in several high yield rated countries over the last few years, corporate spreads have in many cases widened, despite relatively strong fundamentals. The spread differential between EM investment grade corporates and EM high yield corporates also remains at elevated levels compared to the averages of recent years, suggesting that relative value is still on offer in the high yield segment of this universe.
High Yield Continues to Offer Good Relative Value Versus Investment Grade in EMs
Source: Bloomberg. As of December 31, 2019.
Despite these market opportunities, it’s important to remain mindful of the risks that come alongside them. As we discussed in our 2020 Outlook, we believe the single largest risk facing investors in the year ahead is the potential for a material slowdown—or even a recession—in China. While we view this as an extremely unlikely scenario, if it were to occur, it could have serious repercussions on the broader global economy.
The discord in the Middle East is another concern, and any missteps could have very serious ramifications—particularly considering that the region represents about 30% of the world’s energy supply, 20% of global trade passages and 4% of global GDP. This, combined with a number of ESG concerns, has led us to believe that the geopolitical risk in the region is underpriced.
Despite the recent U.S./China trade agreement, we expect to see mixed headlines throughout 2020, and it seems with each passing day another emerging market suffers from political unrest or popular uprising. From Chile to Colombia to Ecuador to Hong Kong, there is no shortage of hot spots. A number of idiosyncratic risks have emerged as well, with Venezuela, Lebanon and Argentina chief among them—in each of these countries, bond prices dropped precipitously as tensions escalated. In fact, during the fourth quarter, nine countries were in default or distress scenarios—the most in a decade.
All of these factors undoubtedly represent risks, and these risks must be taken into account in the form of country and credit analysis. But they also represent opportunity.
When corporate debt issuers are unduly punished for the country in which they are domiciled, or when negative headlines result in an overreaction in a country’s currency, active managers, and therefore their investors, can possibly benefit. Likewise, when it comes to EM sovereign debt, country selection matters—and it matters a lot. And while there are certainly a number of bad apples, there are also bright spots.
The bottom line is that value opportunities exist today across all three of these markets, and will continue to appear going forward. But it’s not a time to ‘buy the market.’ Rather, it will take careful analysis of macro, country and company-specific risks, and the willingness and ability to move quickly, and with intention, when opportunity arises.
1. Source: J.P. Morgan. As of December 31, 2019.
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