EMD: Light at the End of the Tunnel
Emerging markets (EM) debt continued to gain ground in the fourth quarter as news of the vaccine and higher commodity prices jumpstarted the rally that had begun to slow toward the end of the third quarter. Encouraging data out of China, a key driver of EM economic prospects, also contributed. Capping off a year that saw sell-offs rivaling some of the largest in history, sovereign, corporate and local debt ended the year in positive territory, returning 5.26%, 7.13% and 2.69%, respectively.1 Spreads tightened across the board, retracing nearly all of the widening experienced at the onset of the pandemic. Even currencies, which have lagged through the recovery, saw a small bounce-back—but they remain well-below pre-pandemic levels.
FIGURE 1: EM DEBT YEAR-TO-DATE PERFORMANCE
Source: J.P. Morgan. As of December 31, 2020.
Local Currencies: A Bright Spot Ahead?
While EM currencies are still lagging overall, a number of tailwinds have emerged that could create a potentially compelling opportunity in the asset class going forward. For one, many emerging markets, because they have faced weaker consumption as well as outflows on the heels of the pandemic, have been running smaller account deficits in aggregate—with some countries now running current account surpluses. In countries like Brazil, Mexico, South Africa and Indonesia, for instance, deficits have either significantly narrowed or turned into surpluses. Essentially, this means the financial needs of EMs have come down, or in other words, their balance sheets are in better shape. At the same time, exports from many EM countries have performed much better than expected as demand for commodities proved to be fairly resilient and underwent significant recoveries in the second half of 2020—helped by sustained demand from China.
This combination of factors, in our view, suggests the forces may be in motion for currencies to reverse their underperformance in the months and year ahead, particularly if flows return to emerging markets. As follows, we believe EM local currencies currently offer significant upside potential.
Sovereigns: Continued Divergence
On the credit side, EM sovereign debt continues to face challenges, though the effects of the pandemic have varied widely from country to country. Generally speaking, downgrades and defaults have remained below initial expectations—and the rollout of the vaccine, coupled with higher commodity prices, should help keep defaults measured in the coming year. On balance, we continue to see particular value in countries that are investment grade-rated, including Columbia, Mexico, Romania and Brazil—a country that we rate internally as investment grade. On the high yield side, we remain focused on avoiding countries where financing measures are deteriorating. However, we do see select opportunities in countries like Ukraine, which has managed the crisis relatively well.
That said, while fourth quarter performance was broadly strong—and spreads at the index level retraced all, or nearly all, of 2020’s widening—there was sizable dispersion in the total returns on the debt of the 70+ countries in the J.P. Morgan EMBI Global Diversified (EMBIGD) index. Indeed, some countries’ debt ended the year in positive territory, while other countries substantially underperformed. That is to say, country selection matters, and it matters a lot. Particularly in an environment wrought with unknowns, EM sovereign debt should not be thought of as a beta asset class—rather, it is an asset class with great diversity of opportunity, but one that requires active management to select the right credits and, perhaps more importantly, avoid the wrong ones.
Corporates: Adapting to the New Normal
Like their developed market counterparts, EM corporate debt suffered indiscriminately at the onset of the pandemic but shortly thereafter staged an impressive comeback as stimulus and other relief measures provided a much needed lifeline—not only from the Fed and ECB but also from EM central banks and governments. Signs of a more sustained recovery in commodity demand from China later in the year provided further support to the asset class.
While the vaccine news did advance the rally in the fourth quarter, there remain high execution risks with the governments’ rollout of the vaccines, with many EM countries not expected to reach scale in their rollout programs until the second half of this year. Most likely, EMs will lag their developed market counterparts, suggesting COVID-induced restrictions could remain in place in some countries for a while longer—albeit with a bit more light at the end of the tunnel. To that end, it remains crucial to identify those business models that are resilient enough to withstand an extended period of softer demand, or are able to adapt to the new normal. We continue to see value in companies in defensive sectors like utilities, consumer and telecom, media & technology (TMT), for instance. Corporates with innovative business models that are exposed to structural trends across EMs—including e-commerce and food delivery companies—also look more resilient. In fact, we are already seeing new issues and new supply from these types of companies, and expect to see more in the months and year ahead. Conversely, companies in the COVID-sensitive transport sector—from airports and airlines to highways—and gaming companies may continue to face challenges.
There are certainly bright spots across the EM universe, and we expect to continue seeing opportunities as the vaccine is deployed and economies around the globe begin to open back up. Nonetheless, there is no shortage of risks facing EM sovereigns and corporates—from political tensions to the longer-term potential for rising rates in developed markets, as well as the reduction in support measures such as bank moratoriums and regulatory forbearance measures, which could present potential risks to the market. In this environment, active management, coupled with a bottom-up approach to identify the most resilient countries and credits, remains paramount.
1. Source: J.P. Morgan. As of December 31, 2020.