Capital Ideas^TM

During the third quarter, emerging markets (EM) bonds posted broad-based gains across local- and hard-currency-denominated sovereign and corporate issuers. Market expectations that the Fed would pivot to more accommodative monetary policies provided a supportive risk backdrop for the asset class.

Local rates markets rallied across all regions, led by sharp gains in African and Asian local sovereign bonds. Emerging markets currencies mostly gained ground on the US dollar, with the Malaysian ringgit experiencing some of the strongest investor demand. Conversely, a number of Latin American currencies declined during the period. For example, the Mexican peso fell sharply versus the US dollar.

Hard currency sovereign bonds produced gains across all regions and ratings cohorts during the period. High-yield sovereign spreads narrowed by roughly 60 bps, while investment-grade sovereign spreads were largely unchanged. 

In our view, the fundamental backdrop for emerging markets debt remains supportive. Growth is positive across many major economies and fiscal deficits have largely stabilised and converged with developed market levels. Foreign currency reserves have also grown, due in part to recent strength in commodity prices. Real yields across many markets remain positive.  

The Fed’s pivot to interest rate cuts could be a catalyst for the US dollar to depreciate against a broad basket of EM currencies. That said, valuations based on real effective exchange rates suggest that many of these currencies are only modestly cheap, so any upside versus the US dollar may be limited.

Spreads throughout investment grade US dollar sovereign bonds appear tight, while high-yield spreads appear somewhat more attractive, though primarily across the lowest quality distressed issuers. EM corporate bond valuations also appear reasonably tight compared to their historical averages.   

We believe ongoing economic deceleration in China is a key near-term risk for the asset class. Weak demand from Chinese consumers could negatively impact EM commodity exporters.

Risk in our portfolios remains balanced and diversified. The EM portfolio management team continues to favour local duration exposure across sovereign issuers with high real rates. More modest allocations to lower yielding, high quality local issuers provide a potential buffer against any uptick in volatility. 

Despite tight spreads, we’re finding select relative value opportunities across investment-grade US-dollar-denominated sovereign and corporate issuers. Limited exposure to distressed sovereign credits continues to provide attractive yield opportunities for our portfolios.