Outlook 2020: Emerging markets debt relative
- After generating a double-digit return so far this year, EMD still has room to run in 2020 as a large part of the return has been due to falling global bond yields, rather than EM-specific rising prices.
- With the Fed on hold, we expect the next driver of returns to be a turn in the US dollar, which is still at elevated levels.
- Dollar and local currency EMD index returns have been uniformly strong this year. 2020 is likely to produce a similar return profile, but with better upside for local debt, should the dollar weaken.
Like the rest of fixed income, emerging market debt (EMD) enjoyed the global bond rally, as central banks eased monetary policy consistently in 2019. Additionally, the spread between Treasuries and the benchmark EMD dollar index fell from 400 basis points (bps) to about 340bps as the Federal Reserve (Fed) switched gears to easing.
The combination led to double digit year-to-date returns across dollar and local currency EMD indices.
How do valuations look after strong year-to-date performance?
Despite strong year-to-date performance, overall valuations are fair but not expensive. Current spreads represent a mid-point between the start of the Fed’s indication that rate hikes were over, and the near-term historical lows of February 2018. With very low yields available across most mainstream developed fixed income markets, EM dollar index yields of just over 5% remain attractive.
To achieve a price gain on top of the available income, it will likely require the US dollar to fall from currently elevated levels. In spite of Fed rate cuts, the dollar has appreciated about 3% in 2019. Any relative weakening of US growth prospects compared to the rest of the developed world, that contributes to a weaker dollar, would likely be very beneficial to the EMD return outlook.
Why the fundamental outlook remains broadly supportive
While economic growth is sluggish globally, overall EM growth is still about twice as high as the developed world. Regionally, Latin American growth is the most troublesome, with close to zero growth in Brazil and Mexico and a recession in Argentina. European EM growth is steady at just over 2% in most places, while EM Asia growth remains relatively robust, despite slowing in China and India. Catalysts for upside surprises appear scarce, unless developed countries embark on more determined fiscal stimulus.
The good news, however, are the low and stable inflation rates across a broad swath of the asset class. These have allowed for interest rate cutting cycles that have boosted local returns, and more rate cuts are likely in Russia, Mexico, South Africa and Brazil. Stable inflation has also fed into less volatile currencies. That has made the large yield advantage in local debt more attractive for investors on a risk-adjusted basis.
To us, this seems like a structural change that will over time reduce funding costs in local currency and should lead to more stable and predictable rate cycles that improve investor confidence.
Perhaps the biggest risk does not stem from broad macroeconomic factors, but individual country hotspots. We expect Argentina to embark on a debt re-profiling. Lebanon, as we write, is trading at distressed levels with significant governance questions, and Ecuador is struggling to pass fiscal reforms despite a market friendly executive.
As these trouble spots have arisen, contagion into neighboring countries or more broadly into EM has not occurred. This suggest that the market has differentiated these risks and favors those countries best able to take advantage of the positive macroeconomic tailwinds.
Where are the opportunities in 2020?
We see value across a number of diversified themes next year:
Those EM countries where the macroeconomic outlook is improving are amply rewarded by investors. Brazil’s progress on pension reform, with a roster of other potential reforms to follow, has led to over 14% returns on dollar bonds. Russia’s large current account surplus and sound policy mix has given investors an over 18% return.
Although outsized gains might be harder to come by, incremental improvements in governance in places like Turkey and Mexico, where expectations are low, offer potential for gains. In lower-rated sovereign credits, those with stable IMF-approved frameworks like Ukraine have out-performed. Going forward, there is likely to be less dispersion in returns and a diversified sovereign exposure across rating categories is likely to be the best way to access this part of the opportunity set.
Within corporate debt, companies within those improving countries offer great opportunities to pick up yield over sometimes stretched sovereign valuations. One seemingly structural improvement to note is the increasing ability of corporate issuers to access markets to refinance debt maturities in the current low rate environment. This is likely to improve credit profiles and reduce downside risks.
In local currency, those countries with higher real interest rates seem best poised to continue to outperform. Indonesia, Russia, and Mexico offer investors higher rates with a greater potential for price appreciation as other local opportunities fade. If the dollar does turn down, the central European complex that trades with a high correlation to the euro are likely to do very well. High grade Asia offers currencies that have very low volatility that should also out-perform in a falling dollar environment.
You can read and watch more from our 2020 outlooks series here
To find out more about the Emerging Markets strategic capability, please click here.
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