We remain cautiously optimistic on EMD Hard Currency in particular, as we believe there are two supportive factors at play – the dovish Fed and the constructive outlook on commodities.
Performance has returned. Emerging Market Hard Currency Debt is enjoying a strong start in 2019, rising 7.2% through 10 May, following a -4.3% decline for the full year of 2018. Both the High Yield and Investment Grade segments performed well, rising 7.8% and 6.7% respectively YTD, as the US Fed announced a more dovish stance in January and as oil rose 31.3%, partially recovering the 35% decline in brent crude prices in the final quarter of 2018. Until May, expectations of improvement in the US-China trade conflict also helped overall performance of risky assets, until the trade talks broke down in early May and the US and China announced new tariffs.
Global growth continued to disappoint but this did not impact EMD Hard Currency as much as it did EMD Local Currency. Those EM currencies which are traditionally correlated to the differential in economic growth rates between emerging and developed market are flat YTD, at -0.3%. Certain EM interest rates, those which started the year with material risk premiums versus US Treasuries, were supported by the 21 basis point decline in 10Y US Treasury decline, and posted a 2.8% return through May.
We believe that the core drivers of the emerging market debt asset class are reasonably stable. From a top-down, external risk perspective, EMD can be expressed as a combination of Interest rate, EM credit, and liquidity and volatility risk premiums. As the interest rates are generally driven by the performance of US Treasures, our outlook focuses on US interest rate risks, while for EM credit, we obviously consider the evolution of EM credit-worthiness. Interest outlook inputs include the predictability of US monetary policy, the pace of the Fed’s balance sheet unwind and their impact on US Treasuries, while our outlook for EM credit risks considers Chinese, EM and global growth as well as the link of the latter to commodities, as most EM countries in the universe are still dependent on commodity exports.
To assess the outlook within specific EM countries, we incorporate political risks, structural reform trends, and the evolution of EM fundamentals/valuations/technical dynamics within countries. We continually monitor and assess specific geo-political events and investment themes such as the structural decline in global trade which may change our outlook for EM and global growth and the generic global market risk environment.
The generic valuation of the asset is an important consideration as it determines the asset allocator demand for the asset class and the pace of inflows into the asset class. EMD Hard Currency risk premiums are, ultimately, mean-reverting. That is, if investors assess that valuations are sufficiently attractive, and countries are unlikely to default, they will buy 'cheap' bonds in anticipation of risk premiums or EM spread compression and bid the price back to 'normal'.
The dovish Fed and the constructive outlook on commodities provide two supports for EM Debt markets, so we remain cautiously optimistic on EMD Hard Currency in particular. Chinese, EM and global growth have all disappointed YTD, but US growth has been closer to expectations. This US growth exceptionalism may not be long-lived in an environment of sharply higher US tariffs on Chinese goods, as the cost is likely to be split across both countries. Scenarios for the US-China trade dispute are difficult to model but we remain convinced that sharp escalation of trade tensions is unlikely, as equity markets corrections in each of these countries are likely to elicit political softening of negotiation positions.
We do not expect global or EM growth recovery in 2019, but stable growth is sufficient for EM sovereign, corporate and EM rates markets to do well. Given the current 6% yields for both EMD HC and EMD LC, we would conservatively expect that at least the interest carry is realized. That is, we therefore expect around 6% returns for each sub-class, EMD HC and EMD LC, on a one-year horizon.
In the long term, we remain constructive on EMD as the asset class offers a structurally attractive upside to alternative fixed income asset classes in environments of stable core interest rates, supportive global growth and improving EM fundamentals.
In EMD Hard Currency, we prefer to retain exposure to countries or companies with improving fundamentals, with positive technicals, or very cheap or distressed credits. Examples of sovereign issuers with improving fundamentals include Angola and Egypt, while examples of positive technicals would be index inclusion for Gulf Cooperation Council countries such as Bahrain and Qatar. For very cheap or distressed credits, we would include Argentina or Tajikistan.
We took profits in a number of Sub-Saharan African countries, such as Angola, Gabon, Kenya, and Nigeria after their impressive performance YTD. We await Eurobond issuance to add to these positions again. We retain an under-weight in Turkey until the government produces a more credible bank recapitalization plan, and until political risks subside, including local elections in Istanbul or the purchase of the S-400 anti-missile defence system from Russia.
In EMD Local Currency, we prefer to retain exposure to EM interest rates more than exposure to EM currencies. We prefer bond markets that offer high risk premiums versus US Treasuries, have subdued inflation, and credible and independent central banks. Some of the sovereigns meeting these criteria include Indonesia, Mexico, Peru and South Africa. We need to confirm that the US Dollar strengthening trend is subsiding before engaging with EM currencies. We do not favour Central and Eastern European markets at present, where inflation is resurfacing and central banks do not appear to be acknowledging the risks of over-heating.