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Fixed Income

Emerging Markets Debt: Taking a Hard (Currency) Stance

2019 October - 3 min read

EMD performance was muted in Q3, but valuations remain attractive and emerging economies are growing at a measured pace. We continue to favor hard currency assets, which are benefitting from lower rate expectations.

Highlights

Resilience Amid Challenging Conditions
Performance across emerging markets debt (EMD) asset classes was muted in the third quarter as a number of geopolitical risks continued to unfold across the EM landscape. Returns were positive across hard currency EMD asset classes—where emerging market (EM) corporates returned 1.55% and EM sovereigns returned 1.39%. EM local debt fell 0.62%, weighed down by local currencies, which fell 3.72% overall. Hard currency assets and local rates were buoyed by a sharp fall in U.S. Treasury rates, alongside a dovish U.S. Federal Reserve (Fed) and European Central Bank (ECB).

Argentina Front-and-Center
The drop in EM local was impacted by escalating U.S.-China trade tensions, slowing global trade growth, and falling oil prices, which lost 8.7% during the quarter, even after the drone attack on Saudi Arabia’s largest oil storage facility. EM currencies were mixed—with Turkey and Thailand gaining, while all other local benchmark currencies were negative, led by Argentina and Brazil. Argentina, in particular, was front-and-center as the country started the process of reorganizing its debt. The country fell into technical default following the market’s reaction to the PASO primary presidential election—where President Macri was upstaged by landslide victor Alberto Fernández, and former president Cristina Fernández de Kirchner. Feeling the effects of this acutely, the Argentinian peso fell 26% during the quarter.

EMs Follow the Fed’s Lead
The IMF’s second-quarter economic data pointed to a global growth rate of 2%, the slowest rate since the third quarter of 2016. Global inflation was reported at 2%—with EM inflation at 3.8%. Global trade growth declined to negative 4.9%, the slowest pace since the first quarter of 2016, influenced by China’s cyclical slowdown and the protracted trade war with the U.S. Following suit with the Fed, several countries cut rates during the quarter—including a 0.5% cut by China to the reserve requirement; a 0.25% cut by South Korea, Russia, Thailand and Mexico; and a 0.35% cut by India.

Outlook

Generally speaking, we remain positive on EMD overall, as we believe valuations continue to look attractive and EMs continue to grow at a measured pace. However, we are mindful of persistent risks—such as the ongoing trade negotiations between the U.S. and China, increasing Persian Gulf tensions, and large market swings in currencies, interest rates and bond prices.

  • Opportunities: We continue to favor hard currency assets, and believe sovereign and corporate bonds remain the most attractive in the current environment, benefiting from lower rate expectations and healthy economic growth. Local rates remain attractive, in our view, as governments continue to follow fiscal consolidation programs while trying to stimulate their economies. On a regional level, Latin America continues to provide some of the most attractive investment opportunities from a risk/return perspective, and we also find value in certain Eastern European hard currency high yield issuers. Overall, we favor countries with the flexibility to adjust to an uncertain future, given the fluctuations in commodities, core interest rates and developed market growth.
  • Beyond the Index: Across emerging markets, we are seeing some of the most attractive opportunities beyond traditional indexes. For example, when it comes to sovereign debt, we are finding opportunities in countries like Albania and Macedonia, even though those countries are not included in the index today. We are also comfortable taking zero exposure to countries that we don’t believe have a favorable risk-reward profile, even if they are included in the index. For instance, we think the political risks are currently underpriced in the Gulf Cooperation Council (GCC) countries, and as a result have virtually no exposure to the region—a sizeable view to take versus the index.
  • Risks: The key risks for the remainder of the year continue to lie in U.S. trade policy and its potential impact on global trade, as well as heightened tensions in the Middle East. Despite dovish central banks and upcoming trade meetings between the U.S. and China, we do not see a strong catalyst for overall currency appreciation at this time. Investors must be discerning with respect to currency selection, given the effect of lower rates on FX—as well as EM countries’ practices of using their currencies as shock absorbers, and as a means of making exports more competitive on the global market to boost economic activity.
  • Selectivity: We remain optimistic given the current backdrop for EMs, which has improved markedly since December 2018, and is very much supported by dovish central banks. But rigorous bottom up-analysis, security selection, active management and risk mitigation remain paramount—as we discussed in the recent Insights piece.

GLOBAL INFLATION & TRADE AT MULTI-YEAR LOWSSources: Bloomberg Professional, Haver, Barings. As of June 30, 2019.

THE RISE OF NEGATIVE-YIELD DEBTSources: Barings LLC, IIF, Bloomberg Professional. As of June 30, 2019.

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