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Does the EM debt repricing present a good entry point?
Harry Phinney
May 5, 2022
The Russia-Ukraine conflict, a spike in commodity prices and rising global inflation have raised fresh questions about the outlook for emerging markets (EM) debt. Recent forecasts from the International Monetary Fund and World Bank suggest global growth is slowing. And the U.S. Federal Reserve appears set to front-load rate hikes in this tightening cycle, heightening the risk of a recession.
Against this backdrop, it’s no surprise that the asset class has been under pressure. But are we at a point of maximum pessimism, where much of the risk is priced in? With the average yield on benchmark EM indexes in the 6% to 7% range, is now a good entry point into the asset class?
While this is a heterogenous universe, demanding discrete analysis for each sovereign and credit instrument, our investment team’s research shows many developing economies are now in better shape than they have been in the past. Therefore, a cautiously optimistic view may be warranted for emerging markets debt. Here are a few broad trends that support that conclusion.
Heading down the right path on inflation
Many emerging markets central banks began raising interest rates much earlier than their developed-market (DM) counterparts in this cycle. Policymakers are keenly aware of the detrimental economic impacts caused by structurally high inflation, having dealt with it frequently in the past. While higher inflation is mainly being driven by more volatile factors (food and energy) across these economies, EM central banks have to work harder at proving their credibility and to avoid inflation expectations becoming entrenched. Higher interest rates also help protect EM countries against capital outflows as the Fed starts to raise rates.
Many EM countries have aggressively hiked policy rates
Source: Bloomberg. Data as of April 27, 2022.
Valuations in some markets provide fair compensation for elevated inflation
Nominal and real yields in a number of developing countries appear to provide fair compensation for elevated inflation. Interest rate differentials between EM and DM countries have moved back in line with historical averages on both a nominal and real basis, while analysis shows EM currencies to be cheap.
EM local, hard currency bond yields top those of U.S. core bonds
Sources: J.P. Morgan, Bloomberg. U.S. dollar EM debt, represented by J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified; local EM debt, represented by J.P. Morgan Government Bond Index — Emerging Markets (GBI-EM) Global Diversified; U.S. core debt, represented by Bloomberg U.S. Aggregate Index. Data as of March 31, 2021.
As valuations have cheapened and yields have risen, potentially negative outcomes appear to be at least partially priced in across some EMs. As the chart below indicates, historically, two-year returns have been positive when yields reach 6.7% or higher. The current yield level, based on a 50/50 blend of the EM hard and local currency sovereign bond indexes, stands at approximately 7.07%, as of April 29, 2022. High starting yields can help offset subsequent price volatility and may signal an attractive entry point for investors seeking to add income-generating bonds to their portfolios.
EM yields have risen and fundamentals appear stable
Source: Bloomberg, J.P. Morgan, Morningstar. Data as of April 5, 2022. Yield-to-worst and forward returns callouts shown are for 50% J.P. Morgan EMBI Global Diversified Index (hard currency) / 50% J.P. Morgan GBI-EM Global Diversified Index (local currency). Callout dates for yield peaks are: 5/31/2010, 9/30/2015, 12/31/2015, 10/31/2018, 11/30/2018 and 12/31/2018. Forward returns based on annualized returns. EM: emerging markets. YTW: yield to worst. Yield to worst is the lowest yield that can be realized by either calling or putting on one of the available call/put dates, or holding a bond to maturity. Calling and putting refer to features of some bonds that enable an issuer to redeem the bond early, or a bondholder to demand early repayment from the issuer.
Stronger balance of payments despite higher fiscal deficits
Fiscal deficits rose in many emerging economies during the pandemic but appear largely manageable as these countries’ stimulus measures tended to be limited compared to those implemented across developed markets. Broadly speaking, EM public debt levels also remain well below those of developed markets. Many balance-of-payment positions (a measure of the difference between all of the money flowing in and out of a country) improved during the pandemic, as COVID-19-related restrictions weakened domestic demand and undervalued exchange rates helped EM countries’ competitiveness. Some emerging markets even have current account surpluses.
Commodity exporters benefiting from favorable prices
The recent spike in commodity prices is supportive of many commodity-exporting EM countries. They are benefiting from gains in terms of trade, which in turn can help correct external and fiscal imbalances as well as mitigate the impact from weaker global growth. Latin American commodity exporters stand to gain the most from higher commodity prices, especially as they have few direct trade links with Russia and Ukraine. Most EM Asian countries are net commodity importers and so may see external balances deteriorate, although many are running current account surpluses. The EMEA region (Europe, the Middle East and Africa) is mixed, including some countries that are likely to be hit the hardest by the spike in commodity prices, such as Turkey, and some that will benefit the most, like oil-exporting countries in the Middle East. That said, commodity prices are only one factor affecting these economies. For instance, political risk can become a dominant factor in an election year. This and other drivers of volatility may temper any near-term upside.
The technical backdrop is supportive
Primary market issuance has slowed since mid-March, while interest payments and principal redemptions have exceeded the amount of new issuance, contributing to a supportive technical backdrop. Meanwhile, investors appear to have taken a less favorable view of EM debt recently. According to Barclays, EM debt mutual funds and exchange-traded funds have seen US$13.5 billion in outflows year to date through April 19, 2022. As EM central banks continue to raise rates, widening the interest rate differential with developed markets, we could see a meaningful turnaround in flow activity.
Current volatility could create an opportunity
Our investment team favors a well-diversified portfolio in our core emerging markets debt strategies, with exposure to local currency and dollar-denominated sovereign debt as well as corporate bonds. We don’t like to stack risks to any one view or belief, and that’s even more true in this market environment.
The combination of relatively weak global growth and high inflation remains a challenging backdrop for EM debt, especially with a more front-loaded Fed hiking cycle. On a more positive note, proactive central bank actions, fundamentals and technical factors look attractive on a historical basis and relative to developed markets. From a valuation perspective, and acknowledging that past results are not indicative of future performance, when yields have been at or near current levels, long-term returns in EM debt have historically been positive. With this in mind, the current volatility in the asset class could be a good entry point for long-term investors.
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The J.P. Morgan Emerging Market Bond Index (EMBI) Global Diversified is a uniquely weighted emerging market debt benchmark that tracks total returns for U.S. dollar-denominated bonds issued by emerging market sovereign and quasi-sovereign entities. This index is unmanaged, and its results include reinvested dividends and/or distributions but do not reflect the effect of account fees, expenses or U.S. federal income taxes.
J.P. Morgan Government Bond Index — Emerging Markets (GBI-EM) Global Diversified covers the universe of regularly traded, liquid fixed-rate, domestic currency emerging market government bonds to which international investors can gain exposure. This index is unmanaged, and its results include reinvested dividends and/or distributions but do not reflect the effect of account fees, expenses or U.S. federal income taxes.
The Bloomberg U.S. Aggregate Index represents the U.S. investment-grade fixed-income markets. This index is unmanaged, and its results include reinvested dividends and/or distributions but do not reflect the effect of sales charges, commissions, account fees, expenses or U.S. federal income taxes.
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