Tensions between uncertainties over growth, typical in the late stages of the economic cycle, and the dovish response from the Federal Reserve mean the journey ahead for EM as a whole will likely be circuitous, punctuated by bouts of volatility that separate the strong from the weak. PIMCO sees many opportunities within the asset class by focusing on alpha potential.
For investors, we see opportunities across all three EM asset classes:
- External sovereign debt offers a strong combination of high yields and defensive characteristics that are attractive during late-cycle volatility, and it can potentially benefit from an end to the tightening in U.S. monetary policy.
- Corporate bonds continue to show impressive improvements in credit quality and can offer investors selective portfolio diversification.
- Local currency bonds, hard hit in 2018 by U.S. dollar strength, should benefit from a stable-to-weaker dollar, reflation in China and greater scope for central bank accommodation. EM local markets remain our preferred long-term investment vehicle.
An important consideration in our overall positive view is that we see EM in general as an attractive source of portfolio diversification alongside its ability to enhance return potential. Accordingly, we would encourage investors to think of emerging markets as a longer-term investment that offers potentially high carry rather than as a shorter-term trade.
HOW THE BIG PICTURE PLAYS OUT
The most important point for EM performance, particularly local market assets, is that slowing global growth and the mature interest rate cycle in the U.S. mean that the U.S. dollar’s strength is likely to be constrained.
The recent dovish shift in the Fed’s outlook points to the lowest terminal real fed funds rate in any modern tightening cycle. For emerging markets, an end to both dollar appreciation and a rising fed funds rate would allay concerns about a tightening in financial conditions.
A clear turn weaker in the dollar − perhaps if the Fed seeks to buffer slowing U.S. growth with a reversal of past tightening − would be icing on the cake, arguing for a more aggressive shift in favor of local over external EM debt. But until there is evidence of a sustained slowdown in U.S. growth, we believe it is premature to call for a significant reversal of dollar strength.
As a counterbalance to our constructive view, we do see risks. China’s potential for debt stagnation following its long credit boom deserves mention. With the Fed signaling a likely end to its tightening cycle, China should have the flexibility to pursue domestic stabilization efforts without resorting to a large currency depreciation.
Market volatility and geopolitical tensions are also risks. Accordingly, we continue to emphasize bottom-up credit assessments, which integrate a broad set of material ESG (environmental, social, and governance) risks, and employ a selective approach to EM investing, prioritizing quality and idiosyncratic stories that are less correlated to the broader market. And with market liquidity lower during the transition away from quantitative easing, we think scaling EM positions appropriately is just as important as having the constructive view in the first place.
EXTERNAL DEBT: ATTRACTIVE YIELDS
While much was made of EM currency weakness (and U.S. dollar strength) in 2018, we believe the free-floating currency regimes in most EM economies both protect sovereign balance sheets and shore up the balance of payments.
Spreads on external debt widened last year, along with many credit assets as the Fed tightened, but in most cases EM economies had very little external debt – and thus limited vulnerability from a debt dynamics perspective. This newfound resilience allows for a faster recovery in both growth and asset prices from negative shocks.
We expect to see good relative value opportunities arise from the divergent policies of new governments in Brazil, Colombia, Malaysia and Mexico, and similarly from the likely fears surrounding key elections in Argentina, Indonesia, India and Ukraine. We do not see big shifts in major EM economies but rather marginal and gradual improvement (e.g., Brazil) or deterioration (e.g., Mexico). We think the biggest credit risks in 2019 will likely emanate from the smaller countries, including in sub-Saharan Africa (Zambia, Gabon), Central America (Costa Rica) and the Middle East (Lebanon).
From a valuation perspective, EM external debt appears attractive after the sell-off in late 2018 and the subsequent rally in January. Despite vulnerabilities from the softer global growth backdrop, this risk premium seems quite generous to us for an index that will have a weighted average investment grade rating once high quality Gulf Cooperation Council (GCC) credits are added over the course of 2019.
For investors, the robust 6.1% yield on the JP Morgan Emerging Markets Bond Index Global (EMBIG) stands out. Rising rate differentials between U.S. Treasury bonds and local bonds in Europe and Asia have shrunk the universe of dollar-denominated fixed income sectors offering attractive returns after hedging costs. And for investors wary of the higher volatility in EM local debt, the asset class provides dollar-denominated exposure to emerging market fixed income.
CORPORATE DEBT: WIDE SPREADS DESPITE IMPROVING TRENDS
The underlying credit quality in EM corporates is strong and improving, with EM corporate net leverage at its lowest since 2012, according to JP Morgan. Revenue improvement was broad-based in 2018, with about 80% of issuers in the Corporate Emerging Market Bond Index (CEMBI) improving their top line; EBITDA (earnings before interest, taxes, depreciation and amortization) margins were also better on average, and we saw this translate into a further reduction in leverage in 2018. The default rate dropped to 1.6% for EM high yield issuers and 0.5% across the CEMBI index. We expect default rates to be low again in 2019 given the comfortable liability profiles of EM corporates.
Many EM companies used the period of easier financial conditions in 2017–2018 to improve their financing positions, reducing all-in coupon rates, extending duration and actively reducing near-term liabilities through tenders, calls and buybacks. In fact, the Latin American and European sub-segments of the EM corporate sector actually saw negative net financing in 2018, leaving net issuance to higher-rated Asia and the Middle East. Overall new issuance for 2018 was down 23% for the year at $370 billion, and we expect similar issuance, if not lower, in 2019.
Wide spreads and cheap valuations in EM corporates may offer the largest performance “buffer” we have seen in a long time. Spreads on the CEMBI widened from their tightest level of 199 basis points (bps) in February 2018 to 345 bps at year-end. Yet, the CEMBI still managed to outperform most fixed income asset classes with a total return of -1.7%. In our view, this speaks to the attractive spreads/yields and short duration of this investment grade index.
LOCAL INVESTMENT: EM CURRENCIES OR BONDS?
Domestic developments in many emerging markets are supportive of local assets, in our view. Importantly, EM domestic interest rates are increasingly less sensitive to exchange rate movements in countries without large current account deficits. Last year’s performance showed a clear divergence between local rates and currencies.
Why does this matter since EM local bond returns were nonetheless negative in 2018? In the near term, the resilience of local bonds to EM currency weakness means that local bonds could still deliver solid performance if the dollar simply remains stable in 2019. More important in the long term, EM policymakers can potentially engage in countercyclical fiscal and monetary policy to support domestic growth. For sovereign bonds, this ability could reduce default risk significantly.
We like both local currencies and local bonds, but for different reasons. EM currencies have seen some of the highest volatility among asset classes over the past year, and a basket of EM currencies is still substantially undervalued, based on our analysis. Furthermore, high real rates in these countries can potentially provide investors with positive carry and a cushion against unexpected shocks.
In EM local bonds, the bond component outperformed the currency component considerably in 2018, particularly in lower-yielding EM countries that have generally aimed to anchor inflation. The recent decline in oil prices has been an added catalyst and, coupled with large output gaps in major EM economies such as Brazil and South Africa, creates a backdrop for EM local rates to continue trending lower this year.
Although we expect volatility to continue in local EM assets, for investors with long time horizons, the coming year may offer attractive opportunities for scaling into exposure to the sector.
EM AS DIVERSIFICATION
Diversification benefits have long been a major selling point for EM and a particularly important consideration since market volatility rose in 2018. To examine the diversification properties of EM, we have analyzed the performance of several EM asset classes in light of four main global risk factors: oil prices, credit/equity markets, the U.S. dollar and duration/bonds.
In our analysis, two things stand out. First, the EM asset class betas to global risk factors are declining, suggesting that EM is becoming a more idiosyncratic investment. Second, EM local bonds continue to be the least affected by the big four risk factors, which we believe is a testament to the improvements emerging markets have made in recent years.
We still believe it’s important to have a long-term orientation when allocating to EM; we’ve seen little evidence suggesting that EM volatility will decline. For investors considering an allocation, though, we think the hardest part of the climb may be behind us.