Emerging market debt (EMD) has rallied sharply this year, bouncing back from a tough 2018. Is now a good time to add exposure? We would be buyers on any material sell-offs, as we see fundamentals remaining supportive in coming quarters. Our overall view on emerging markets (EMs) favors equities over debt, yet we believe EMD offers attractive income for bond portfolios.
This year’s EMD rally is evident in how both local- and hard-currency EMD yields have fallen significantly as bond prices have risen. Yield spreads between EMD and U.S. investment grade bonds have tightened as a result. Yet EMD yields remain attractive on an absolute and relative basis over the longer term, as the chart below shows.
Yield spreads between hard-currency EMD and investment grade U.S. bonds hit highs late last year not seen since early 2016. Spreads remain wide in the context of the last few years, even with EMD’s recent out-performance over investment grade and high yield. A reason EMD valuations still appear reasonable: The asset class took a hit last year as the Federal Reserve raised interest rates and the U.S. dollar (USD) appreciated. The backdrop for the asset class this year appears very different.
A different backdrop
We see three major drivers of this year’s EMD rally, all likely to persist into the second quarter. The most important, in our view: The policy backdrop has quickly turned more supportive. A U.S.-led slowdown in global growth as the economy enters a late-cycle phase has prompted major central banks to slow their planned pace of normalization. The Fed’s swift pivot from tightening to a policy pause has helped spur demand for EMD, as has the subsequent waning of USD strength. A pause in the Fed’s hiking cycle eases the burden on EMs with high external debt loads. A softer or stable USD supports EM currencies and underpins local currency debt returns.
The second driver–the most underappreciated, in our view: large demand meeting tightening supply. EMD experienced sharp inflows along with other fixed income risk assets in early 2019. At the same time, market volatility led many EM issuers to postpone offering new debt: January issuance was well below year-earlier record levels. We expect the new-issue market will take time to restart in earnest. Until then, limited new supply should underpin the market. Another driver: Our indicator shows market attention to geopolitical risk has subsided modestly since late 2018, on easing concerns around a significant near-term escalation in U.S.-China trade tensions.
The growth story in EMs is also generally improving following weakness last year. We see policy easing underpinning a modest growth re-acceleration in China during the first half of 2019. More steady growth in EMs should help cushion slowing global growth. The risks to our view: An escalating U.S.-China trade conflict, a return of recession fears or an inflation resurgence sparking earlier-than-expected Fed tightening. U.S.-China trade negotiations look to be progressing, though frictions related to competition for global technology leadership are likely to persist. We have become less concerned about USD strength and see the Fed on hold until at least the second half.
The bottom line
We would look to increase EMD exposure on any price setbacks in the first half, and we maintain our neutral view overall. EMD valuations and income potential are relatively attractive, but the value case is less compelling than it was earlier this year. A relatively stable USD outlook means no clear advantage in hard- over local-currency EMD.