Sovereign debt outperformed in Q1 as geopolitical headlines continued to garner attention and commodities rallied. Risks remain for the asset class but some notable headwinds have now become tailwinds.
Hard Currencies Started Strong: The first quarter of 2019 provided investors with healthy returns across emerging markets debt (EMD) asset classes. EM hard currency bonds realized the strongest returns (at +7.0% for EM sovereign and +5.2% for EM corporates) as U.S. Treasury rates rallied 27 basis points (bps) since the start of the year alongside a dovish U.S. Fed, revisiting levels last seen in December 2017. EM local rallied (+2.9%) on lower inflation numbers, slow growth and accommodative central banks. EM currencies were stronger at the start of the year; however, they realized a pullback in March following idiosyncratic events across Argentina and Turkey, as well as slower growth expectations for Europe. There was no shortage of headlines regarding the U.S.-China trade negotiations; however, there still seems to be a wide gap between parties.1
Elections Influenced Volatility: Geopolitical events and elections across emerging markets led to some volatility, as the political and humanitarian situation in Venezuela continued to deteriorate. Turkey, Ukraine and El Salvador had elections; and South Africa, Indonesia and Israel have upcoming elections. Political noise has risen in Brazil given President Bolsanaro’s ambitious proposal for a pension reform overhaul, and the plan faces a long legislative process.
Monetary Conditions Eased: During the quarter, the U.S. Fed kept rates on hold and indicated no rush to hike—keeping them between 2.25% and 2.5%—thereby providing a warning that economic growth activity may have slowed from its solid rate in the fourth quarter. China also took actions to ease monetary conditions to spur growth—which we discussed in our recent piece, Monetary Policy’s Effect on EM Debt. Commodity prices were sharply higher during the first quarter, with Brent Crude rallying 27% and the Core Commodity CRB Index rising 8%.1
Overall, we find EM debt valuations to be relatively attractive on a fundamental basis. Generally, emerging markets do well during periods of central bank dovishness and positive economic growth. However, risks persist surrounding the ongoing trade negotiations between the U.S. and China, interest rate moves, local elections and currency fluctuations.
- Where We’re Seeing Opportunities: We continue to take a constructive view of EM debt as a whole, and find hard currency bonds most attractive in the current environment, benefiting from lower rate expectations and healthy economic growth. Local rates remain attractive, in our view; however, investors need to be selective, especially with respect to currencies without a tailwind for potential appreciation.
- Remaining Attentive to Key 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, especially as the U.S.-China trade deficit continues to widen. Investors must be discerning with respect to currency selection, given EM countries’ practice of using their currencies as shock absorbers, as well as a means of making their exports more competitive on the global market to boost economic activity.
- Selectivity Remains Crucial: There is much to be optimistic about in the current backdrop for emerging markets, which has improved markedly since 2018. Careful security selection, active management and risk mitigation remain paramount.
We discussed our outlook in more detail in our recent podcast, EM Debt—A Brightening Picture?
EM vs. DM Inflation and Growth21. Source: J.P. Morgan. As of March 29, 2019.
2. Source: International Monetary Fund, World Economic Outlook Database. As of April 2019.