In focus

Where is the value in EMD in a post-pandemic world?


Since Covid-19’s impact sent markets tumbling, the world has become awash with liquidity and risk assets everywhere have rallied.

Emerging market debt (EMD) is no exception. But after some strong performance since the market lows, we look at what might lie ahead for both US dollar-denominated EMD and local currency-denominated EMD.

  • Our full research is available as a PDF here.

US dollar EMD

How has it performed this year?

Emerging markets - faced with historic shocks to public health, growth, fiscal accounts and global capital flows - were quick to sell off in the immediate aftermath of the Covid-19 crisis.

Between 19 February and 23 March 2020, the JPMorgan Emerging Market Bond Index (EMBI) of dollar-denominated EMD fell -21%.

Since then, the unprecedented expansion of global liquidity has sparked an impressive recovery. US dollar EMD rallied nearly 25% from the lows in March to the end of July, leaving the asset class back in positive territory on a year-to-date basis.

1-EMD-total-returns-.JPG

How has the pandemic affected countries’ debt dynamics?

Despite the impressive recovery, the fundamentals behind sovereign debt continue to deteriorate.

According to the IMF, global debt-to-GDP is forecast to rise from 82.8% in 2019 to 101.5% at the end of 2020.

For emerging markets, debt levels are forecast to rise by 10.7% of GDP in 2020, leaving overall debt levels at 63.1%.

2-worsening-fiscal-dynamics-.JPG

What about valuations?

Valuations appear increasingly rich. Current spreads in the investment grade space - particularly for BBB-rated sovereigns - are already tight relative to historic averages dating back to 2005.

There is still value in the high yield segment of the market compared to history, but questions over the extent of underlying credit deterioration and the post-Covid-19 growth outlook have kept the credit curve steep.

What could sustain the rally?

Using our proprietary framework, we gauge the extent to which fundamentals are currently being reflected in relative spread levels.

According to our framework, large policy responses weaken the correlation between fundamentals and prices. This is because prices rush to assume a high probability of a recovery, such as we have seen following the surge of global liquidity this year and as we saw following the global financial crisis (see chart below).

3-correlation-fundamentals-prices.JPG

Our framework indicates that there is still scope for continued US dollar EMD outperformance despite underlying fundamental deterioration.

However, this outperformance comes with three caveats. It is

1) dependent on a supportive external environment

2) requires a strong EM growth recovery

3) leaves the asset class susceptible to aggressive repricing episodes, as was seen during the “taper tantrum” in 2013.

The outlook remains subject to considerable uncertainty, and such a supportive backdrop for the asset class cannot be ruled out just yet, but there are reasons to believe that the post-Covid-19 growth environment may prove less hospitable for emerging markets.

Will we see a V-shaped recovery?

Factors that supported a V-shaped recovery in EM post-global financial crisis - most notably large-scale, commodity-intensive Chinese fixed-asset expansion - are unlikely to materialise to the same extent. The potential for limited fiscal space within EM translating into longer-lived damage via bankruptcies, foregone investment and elevated unemployment will also add to headwinds.

Finally, the impacts of the virus itself will continue to prove meaningful over the next 12-months; even a vaccine approved before the end of 2020 would require time for manufacturing and distribution, meaning growth in 2021 will likely remain below-trend.

In this context, with valuations nearing historic averages and substantially deteriorated sovereign credit fundamentals, the outlook for returns over the next 12-months within EM dollar debt is relatively uninspiring absent a stronger-than-anticipated recovery in EM growth.

Local currency EMD

Local currency investing is arguably more straight forward than the dollar side. The primary driver outside EM considerations as always will be the path for the US dollar.

Where’s the US dollar heading?

With all developed countries pursuing essentially zero rate policies and other forms of monetary stimulus within narrow ranges of each other it is difficult to confidently assume a path up or down for the dollar on that basis alone.

Our assumptions for local currency EMD would be amplified positively by a weaker US dollar, and more negatively by a stronger dollar.

With our 12-month time horizon in mind, there is historically a case to be made that probabilities are skewed more towards a somewhat weaker US dollar. That is, unless a US-specific positive driver emerges that is unrelated to interest rate differentials.

How do we assess EMD local currency return potential?

We determine potential returns by first attempting to estimate where ‘fair value’ might be. The simplest way to do so is to look at where real effective exchange rates (REER) are relative to their history.

The real effective exchange rates is the weighted average of a currency in relation to an index of other major currencies.

Using our proprietary framework we estimate that getting to fair value for the largest countries in the local index would mean an appreciation of over 8%.

Of course, some countries might remain under-valued for specific reasons, but others might appreciate beyond fair value for the same reasons.

How might inflation affect this?

Can we take that 8% number at face value? The most important variable around it, in our view, is the potential for the steep fall in currencies earlier this year to have an inflationary effect.

The mitigating factor here, at least so far, is that the fall in currencies was very short-lived and has already been mostly compensated for.

Therefore, unlike the period of 2014-2016 when the fall in the currency index was long-lasting and produced higher inflation in EM with a 6-12 month lag, the current episode by itself is unlikely to have a similar effect on prices.

Because of that, we think a recovery in real effective exchange rates will likely translate almost directly into nominal appreciation.

What about local currency yields?

In addition to the potential currency appreciation, the current yield on the index is 4.4%, an all-time low. Nevertheless, with zero rates in the developed world there is probably scope for very modest overall rate cuts in the asset class. These could result in modest gains above the index yield.

This is because in a handful of the major economies, real interest rates remain positive.

Therefore, if we put the potential for exchange rate appreciation (8% with modest inflation detracting from average appreciation) along with a yield return of 4.5% (index plus a very small appreciation for future rate cuts where real rates are positive) we get a potential 12-month return of double digits.

What can go wrong?

If our scenario of developed markets signalling a potential liquidity slowdown leads to reduced risk appetite, then a return to fair currency valuations would be delayed or derailed.

If global macro considerations result in significantly reduced risk appetite in developed markets, local currencies would also be unlikely to return to fair value on average. However, their current under-valuation represents a margin of safety that is more significant than current spreads on the US dollar EMD side.

Please find our full paper available as a PDF below.