EM Debt: Fundamentals Back to the Forefront
Emerging markets (EM) continue to benefit from a number of supportive tailwinds—from positive growth and progress in vaccination campaigns, to the stabilization in U.S. Treasury yields. Performance, accordingly, was positive in the second quarter, with sovereign, corporate and local debt returning 4.06%, 2.10% and 3.54%, respectively.1 Spreads, too, continued to tighten across the board. That said, the U.S. Federal Reserve’s hawkish turn at quarter-end introduced some volatility into the markets and led to questions around EM growth. Adding further uncertainty, there are a number of macro and geopolitical risks on the horizon, from the ongoing U.S.-China and U.S.-Russia tensions, to social demonstrations in Latin America and the upcoming presidential elections in Chile.
FIGURE 1: EM DEBT YEAR-TO-DATE PERFORMANCE
Source: J.P. Morgan. As of June 30, 2021.
Sovereign & Local Debt: A Mixed Picture
Despite the Fed’s implication that rates could rise earlier than expected on the back of higher inflation data, we believe the overall growth story for emerging markets remains positive—and should be strong enough to support the creditworthiness of EM economies going forward. Underscoring this, the recovery in the U.S. and Europe should continue to bolster demand for EM goods and services, while growth in China will likely sustain demand for commodities and provide further support to oil prices. Moreover, many of the moratorium and forbearance measures that provided much-needed support last year remain in effect and continue to benefit EMs. Multilateral institutions have also embarked upon debt relief efforts, and we expect EMs to receive roughly $240 billion of the IMF’s special drawing rights (SDRs) in the coming months.2
More challenging, perhaps, are the implications of rising rates for countries’ ability to access external financing. At a high level, an inflationary/rising rate environment will likely result in less financing from foreign investors. Currencies likely face some headwinds ahead, particularly those countries that continue to run current account deficits and are therefore more reliant on foreign financing—such as Colombia and Indonesia. Local rates also face a greater headwind, but will likely be more of a mixed picture. For instance, the many countries that have been able to gradually improve their account balances, in some cases turning them into surpluses, are likely in a better position to withstand outflows. South Africa, Brazil and Mexico are examples.
Sovereign hard currency looks fairly well-positioned in this environment, and may actually benefit from the Fed’s change in stance if it keeps U.S. Treasury yields stable. High yield countries, in particular, continue to look attractive, as spreads in many cases have remained wider relative to investment grade. However, given the diversity and dispersion in performance across the space, country selection is critical. Indeed, as we think about opportunities going forward, it is clear that country selection will play a meaningful role. Whereas general market conditions, or market beta, have been a significant driver of returns over the last several months, we believe the Fed’s change in posture has brought country fundamentals decidedly back to the forefront. In other words, country selection matters now as much as ever, and will be critical to uncovering the right opportunities going forward and avoiding the pitfalls—or “bad apples”—that exist in the space at any given time.
Corporate Debt: Fundamentals Remain Strong
For EM corporate debt, much of the focus in the coming months will be on rates and growth. While the Fed’s latest stance may weaken the technical picture somewhat—as an earlier-than-expected increase in rates could affect demand for corporate bonds going forward—corporate fundamentals remain quite strong and should not be materially impacted by slower growth. In addition to an improving default picture, corporate leverage levels are still in reasonable territory, suggesting most companies should be able to withstand gradually increasing financing costs in a rising rate environment. In fact, in 2020, net leverage levels for EM high yield companies increased less than those of their developed market counterparts (Figure 2).
FIGURE 2: EM VS U.S. HIGH YIELD CORPORATE NET LEVERAGE
Source: J.P. Morgan. As of June 30, 2021.
Given the largely supportive backdrop and positive news around the vaccine, corporate spreads have continued to tighten, with a large portion of the market now tighter than pre-pandemic levels. That said, spreads remain wide relative to both history and developed markets—with the high yield segment of the market, in particular, offering a premium of roughly 50-60 basis points (bps) over their developed market peers.3 This is due partly to the recent re-pricings in countries like China, Peru, Ukraine and Turkey, and suggests there may be further room for compression as those events normalize and the broader recovery advances. However, like in the sovereign hard currency space, credit selection is critical when it comes to capitalizing on opportunities and avoiding risks.
The Fed may have taken some wind out of emerging markets’ sails, but not all asset classes and issuers will be impacted to the same extent. While a rising rate environment likely won’t derail the positive growth story or materially hurt performance across sovereign and corporate credit markets, there may be greater challenges in store for local rates and currencies. In this environment, and as we move to the second half of the year, we believe a strict focus on bottom-up analysis—including the impact of ESG factors on companies and countries—will be a crucial differentiator in performance. Ultimately, we can’t predict exactly when rates are going to move, or how tensions between the U.S. and China or the U.S. and Russia will play out. We do have the ability, based on bottom-up analysis, to choose countries and companies that are well-positioned to withstand a changing environment.
1. Source: J.P. Morgan. As of June 30, 2021.
2. Based on Barings’ market observations.
3. Source: J.P. Morgan. As of June 30, 2021.