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Fixed Income

EM Debt: Cautious Optimism

July 2019 - 3 min read

EMD asset classes—particularly local currencies—came out of the gate strong in the second quarter, driven by central bank stimuli and favorable monetary policy expectations.

Highlights

Strong Start to the Year: The second quarter of 2019 provided investors with solid returns across emerging markets debt (EMD) asset classes. EM local currency led the way with a 5.6% return (4.1% from rates and 1.5% from FX), followed by EM sovereign (4.1%) and EM corporate (3.5%). U.S. Treasury rates fell an additional 40 basis points (bps) during the quarter, for a total of 67 bps this year, amid a dovish U.S. Federal Reserve (Fed) and European Central Bank, revisiting levels last seen in December 2016 following Trump’s election win. The dovish shift in monetary policy expectations produced a bullish sentiment for external debt. EM local rallied as inflation across EM countries remained subdued alongside low growth, leading central banks to continue their accommodative measures aimed at stimulating growth. Despite lower commodity prices, EM currencies ended the quarter stronger—led by the Russian Ruble, Thai Bhat, Czech Koruna and Argentine Peso—on the back of greater financial stability, positive political developments and rising consumer confidence. EM news continues to keep investors tied to their screens—particularly in Turkey, where Erdogan’s party lost in both the April elections and the re-run vote in June. The U.S. and China continued their trade war before calling a temporary truce during the G-20 Summit. Also of note during the Summit, Russia and Saudi Arabia called to extend OPEC production cuts into 2020 as demand for oil slows.

Monetary Conditions Eased: During the second quarter, the Fed held rates steady but signified it was keeping all options open. Markets reacted positively, bringing the 10-year U.S. Treasury yield to 2.01%. A number of EM countries eased—including Russia, Chile, India and Czech Republic—while developed markets also eased—including Australia and New Zealand. In an effort to provide continued stimulus to the Chinese economy, China’s government reduced reserve requirements on real estate and business loans. Amid worries over a slowing global economy, commodity prices fell during the quarter. Brent Crude fell 2.69% and copper fell 7.58%, despite Gulf region shocks. Gold, on the other hand, was up 9.1% during the quarter, reaching its highest level since 2013. 

Outlook

Overall, we remain broadly constructive on EMD, as valuations remain attractive and spreads continue to compensate for default risk. Generally, emerging markets fare well during periods of central bank dovishness. Further, while European growth is softening, we are not seeing the type of sharp and sudden changes to developed market growth that are likely to derail economic growth across emerging economies. However, risks persist surrounding the ongoing trade negotiations between the U.S. and China, tensions with Iran in the Persian Gulf, interest rate moves and currency fluctuations. 

  • Hard Currency Offers Best Value: We continue to favor hard currency assets, as sovereign and corporate bonds tend to benefit the most from lower rate expectations and healthy economic growth. Local rates also remain attractive, however, as governments continue to take measures to try to stimulate their economies. On a regional level, Latin America continues to provide some of the most attractive investment opportunities on a risk/return basis, and we are also finding value in certain Eastern European hard currency high yield issuers. Overall, we favor countries with healthy and well-managed balance sheets that have the flexibility to adjust to changes in commodity prices, core interest rates and developed market growth.
  • But Risks Remain: The key risks for the remainder of the year surround U.S. trade policy and its potential impact on global trade, especially as it relates to the expanding U.S.-China trade deficit. Despite dovish central banks and a temporary trade war truce, we do not see a strong catalyst for overall currency appreciation at this time. We believe it is as critical as ever to be discerning about currency selection, given EM countries’ practice of using their currencies as shock absorbers, and as a means of making their exports more competitive on the global market to boost economic activity. 
  • Selectivity Remains Crucial: In the current backdrop for emerging markets—which has improved markedly since December 2018—there is much to be optimistic about. But risks remain, and as we look ahead to the remainder of 2019, we believe a strict focus on rigorous, bottom-up security selection, coupled with active management, will be a key differentiator in performance.

 

EM vs. DM Inflation & GrowthSOURCE: International Monetary Fund, World Economic Outlook Database. As of April 2019

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