EMD: Further Room to Run?
After experiencing a sell-off in the first quarter that rivaled some of the largest in history, emerging markets debt (EMD) asset classes rallied back aggressively in the second quarter—but the recovery has not been uniform. As central bank liquidity flooded the system, rates were the first to react, followed by investment grade rated issuers and then high yield. Currencies continued to lag, due in part to their close correlation with commodity prices, although they ended the quarter in positive territory. Looking across the space:
- Corporates recovered approximately 60-65% of the spread-widening since the height of the March volatility (60% for investment grade, 65% for high yield).
- Sovereign investment grade credits recovered about 75-80%, versus about 40-50% for their high yield counterparts.
- Interest rates essentially made a full recovery, while currencies have recovered 25-30%.
EM DEBT YEAR-TO-DATE PERFORMANCE
Source: J.P. Morgan. As of June 30, 2020.
Corporates have performed reasonably well, with defensive sectors like telecom, media and technology (TMT), and utilities holding up particularly well through this period of volatility. And while cyclical sectors like oil & gas, metals & mining, and transport were harder hit, they have rallied back notably since March—although some may face additional challenges if we see further increases in coronavirus cases and lockdown measures. That said, certain segments of these industries are more resilient than others. For instance within the transport sector, airlines and airports have been directly impacted, whereas areas like toll roads and gas pipelines have fared better.
The corporate default picture also looks brighter than it did three months ago. Whereas market estimates at the time were trending toward 10%, today they are much lower on the expectation that many companies are likely to muddle through the crisis in a zombie-like state, given the wave of government support, rather than default. Looking across the space today, we see particular value in the high yield segment of the market. After spreads widened out to over 1,000 basis points (bps) in March, they retraced back to about 700 bps—but remain wide compared to their pre-selloff levels (460 bps), meaning there may still be room to run.
EM SOVEREIGN AND CORPORATE SPREADS (INVESTMENT GRADE VS. HIGH YIELD)
Source: J.P. Morgan. As of June 30, 2020.
On the sovereign side, the recovery picture has been somewhat mixed given the large array of sovereigns comprising the universe. We continue to see value in a number of investment grade-rated EMs, including Colombia, Indonesia and Mexico—as well as Brazil, a country that we rate internally as investment grade. Brazil faces a number of challenges, from the severe outbreak of COVID-19 and political scandal to the massive outflow of foreign investment—nearly 15% of all foreign investment has fled the country over the last 18 months.1 That said, the country’s fiscal and monetary policy framework appears to be on very solid footing, and set to withstand even a presidential impeachment if such a scenario were to play out.
Further down the credit rating spectrum, we believe Armenia, Paraguay, Belarus, Macedonia and El Salvador all offer attractive relative value. We are less positive on some of the more distressed countries—primarily Argentina, Lebanon, Zambia and Venezuela. We are also reviewing certain high yield names that require more multilateral financing, like Tunisia and Pakistan, which we believe are trading at interesting spreads, and we continue to assess their ability and willingness to pay their debts.
China, of course, will continue to be a major driver of EMs’ economic prospects, and encouragingly, the economic data that we track—from retail and property sales, to industrial production and steel output—all show strong signs of recovery. Manufacturing rebounded about 80-90% very quickly when the economy reopened.2 And while the consumption side of retail has been lagging, its rate of decline improved materially in May—down just 2.8% after seeing a double digit falloff in March and April.3 While we are keeping close tabs on tariff developments between India and China, asset prices in both countries, thus far, have not been materially affected.
Global trade is likely to be a less positive story. We expect that countries will continue down the recent path of becoming increasingly insular and relying more on domestic production of goods and services—a trend that COVID-19 is accelerating and that may prove to be a long-term structural headwind for EMs.
Overall, technicals continue to drive the market as the ample liquidity pumped into the system by governments and central banks continues to support asset prices. It’s difficult to say if, or when, this will take a turn in the near term. We’ve seen recent signs that fear may be creeping back into the market—as negative headlines on COVID-19 in the U.S., Brazil and other hotspots are digested—and there are risks to both the upside and downside cases for global recovery. But on balance, we think the continued monetary stimulus, along with the potential for a sharper economic bounce-back in the second half of the year, could provide a tailwind to many EMs.
1. Source: Deutsche Bank. As of May 19, 2020.
2. Source: Bloomberg. As of March 31, 2020.
3. Source: Bloomberg. As of May 2020.