After several years of episodic volatility and underperformance of emerging markets, investors have questioned whether the long-term case for investing in emerging market debt still holds. Is the surge in emerging market (EM) returns in 2016 a sign the asset class is attractive once again, or will it slide back to the disruptive pattern? We believe now is a good time to invest in EM, but with appreciation for the current macro risks and a strong emphasis on bottom-up analysis to avoid capital losses.
Global conditions have recently been supportive with the more dovish Federal Reserve limiting dollar strength and lower-for-longer global central banks spurring a search for yield. Also, supply destruction in energy is seemingly putting a floor on prices, and China’s rebalancing and CNY depreciation are proceeding in an orderly fashion (as outlined inour recent Secular Outlook). Meanwhile, within EM, macro fundamentals have shown signs of stabilizing, with growth returning and current accounts improving. These positive developments notwithstanding, there continue to be meaningful risks. For example, a renewed bout of global risk aversion would likely pose headwinds for the emerging asset class, which continues to trade with a heightened beta to global markets.
Still, the backdrop of improving EM fundamentals warrants a more optimistic approach to investing in emerging assets. There are opportunities in both hard currency and local markets for investors looking to increase structural allocations to the asset class. EM valuations are attractive relative to their credit fundamentals and compared to current low/negative yields in developed markets (DM), while market technicals appear supportive with a higher proportion of strategic investors and lower net issuance than in the years after the global financial crisis of 2008.
Moreover, from a total return perspective, the carry cushion in EM bonds relative to DM means that the hurdle rate is high to underperform over the long term, particularly when the starting point is cheap valuations. Together these point to a cautiously constructive outlook for actively managed investments in emerging markets.
Mood shift for EM
The mood is turning more constructive for investing in emerging markets. Total returns are up more than 12% through the end of July for EM hard currency (as measured by the JPMorgan EMBI Global Index), 10% for EM corporate (JPMorgan CEMBI Diversified), 14% for EM local markets (JPMorgan GBI-EM-GD) and 6% for EM currency (JPMorgan ELMI+). These returns warrant a closer look at the balance of risks and opportunities in the asset class, and an assessment of the prospects for future returns.
To begin with, consider that EM fundamentals are showing tentative signs of improvement. USD strength has abated, commodities have stabilized and the outlook for China, while bumpy, is one of muddle-through, not hard-landing. EM currencies have depreciated sharply since 2013, and in some cases have overshot fair valuations, helping kick-start meaningful adjustments in macro fundamentals across EM economies. Growth is accelerating with high frequency variables pointing to stabilization and forward-looking indicators signaling a soft rebound in activity.
On the inflation front, price pressures are muted with headline CPI prints generally contained, or starting to decline from a high base. Most importantly, there has been a significant adjustment in EM external balances aided first by currency depreciation and import contraction, and more recently by improved competitiveness and higher export volumes.
Balance sheet repair is slowly underway. Following the commodities price drop, slowdown in global trade and large depreciations in EM currencies over the past three years, emerging markets experienced deteriorating fiscal and current account balances and declines in EM hard currency savings (in the form of diminishing foreign exchange reserves and sovereign wealth funds). In reaction to this, emerging market policies have started to adjust: safeguarding reserves by allowing more currency flexibility, retracting expensive government subsidies, cutting other expenditures to reduce fiscal deficits and using more conservative macro and commodity price inputs in budget assumptions. EM policymakers are also keeping a closer watch on EM corporate leverage with central banks stepping up oversight of short-term external debt coming due and FX borrowing by the non-financial corporate sector.
For EM as a whole, political and geopolitical tensions look to be receding. In Brazil, the initiation of the impeachment process and suspension of President Dilma Rousseff appear to have triggered a governability circuit breaker. Under current Acting President Michel Temer, political dynamics, while still subject to uncertainty and pork barreling, have taken a more constructive tone. Meanwhile in Russia/Ukraine, geopolitical tensions appear to be “frozen” with strains focused mainly in the Eastern region versus wider Ukraine. Together Russia and Brazil are two of the largest investible emerging markets as well as being two of the most high profile dislocations. We are also seeing a shift toward orthodoxy with several business-friendly governments coming into power, including in Argentina, India and Peru. All this is not to say that EM now has low political/geopolitical risk or is immune from these shocks; in fact, there are exceptions (e.g., Turkey and Venezuela). Yet in certain high-profile issuers these risks look to be stabilizing or retreating.
The resilience of EM to recent exogenous shocks reinforces the secular case for investing in EM. It is notable that the asset class has seen relatively few casualties since 2008 with sovereign defaults limited to very specific cases: e.g., Argentina’s technical default and Ukraine’s preemptive restructuring, among others. Also, corporate default rates are comparable to U.S. high yield (HY) peers even at this fairly mature stage of the credit cycle, reflective of the fact that while balance sheets may have been impaired, they may have not been irrevocably damaged. This speaks to the long-term resilience of emerging market economies which entered the 2008 financial crisis with lower levels of external indebtedness than their developed market counterparts and with higher hard currency savings in the form of reserves and sovereign wealth funds. Flexible exchange rate regimes allowing currencies to adjust by 30%–40% since 2013, improved policy reaction functions, and deeper domestic markets have further provided emerging markets with a strong countercyclical buffer.
From a more structural perspective, long-term economic convergence with developed markets looks to be on track despite the recent concerns about China and the EM-DM growth differential. Emerging markets enjoy favorable population dynamics and significant potential for productivity growth via skills upgrading and investment. Also, policy frameworks are improving and credible institutions remain intact. As developed market growth drivers are stagnating, these favorable EM factors are becoming increasingly important.
Still, some risks ahead
A renewed bout of global risk aversion would likely pose headwinds for the emerging asset class, which continues to trade with a heightened beta to global markets. Further declines in commodities, an increase in volatility and uncertainty related to China, or an overly hawkish turn by the Fed could all easily shift the cyclical outlook for emerging markets.
EM is, after all, part of the global economy and is not immune to the impact of global shocks from both a fundamental and technical perspective. Moreover, due to the compounding impact of concurrent shocks on EM (terms of trade, rates and FX), the beta of EM investments to global shocks has historically been higher than for other credit sectors. Looking at the “known” global shocks we have experienced thus far, our sense is that, currently, risks are marginally tilted to the downside. We see slower-than-consensus Chinese growth along with further CNY depreciation (our forecast is an additional 5% depreciation to the USD from about 6.64 at the end of July), and potential for a hawkish mistake from the Fed given the recent U.S. data. Meanwhile, on commodities we have more of a range-bound outlook (our oil price forecast for 2016 is $50 per barrel in line with forwards). To this we should add the potential for a number of “unknown” global shocks which could also impact EM.
There are also risks emanating from emerging markets themselves. These include the potential for emerging economies to abandon recent policy orthodoxy following several years of demand compression. The combination of the commodities shock together with the China slowdown has meant important declines in domestic demand across emerging markets, with increases in unemployment and declines in real incomes. While the initial reaction of emerging economies and their political systems has been to attempt to shift policies, the adjustment is not over and is likely to compress consumption for some time. This brings into question the potential reemergence of political and geopolitical risks and a shift back toward heterodoxy.
The ability of emerging economies to effectively and politically address structural challenges to unleash long-run growth is yet to be fully tested. While we have seen ambitious structural reforms progressing in Mexico (where President Enrique Peña Nieto began a six-year term in 2012), and reform-minded governments taking over in India (Prime Minister Narendra Modi in 2014) and Argentina (President Mauricio Macri in 2015), these examples are still too infrequent. Moreover it’s not clear to what extent current incumbents have the incentives to tackle these issues as they balance the near-term costs against the longer-term benefits. Nonetheless, failure to do so and the associated economic stagnation would be highly negative in the context of societies with low incomes, high social spending needs and growing populations.
Meanwhile, differing approaches within EM to adjusting to global and domestic challenges have increased the left tails associated with selecting the “wrong” names. In fact, the policy response across EM to recent global shocks has been very diverse even after controlling for initial conditions and the nature of the shock. The result has been increased differentiation across emerging markets, with the most vulnerable economies being those with high leverage/financing needs, stagflationary domestic headwinds and/or pervasive FX mismatches across economic sectors. Moreover, the downside risks associated with some of the worst affected economies can be relatively severe – not all of which have been factored in and priced by the market.
The positive developments in emerging markets, coupled with the global and endogenous downside risks, put greater weight on valuations and market technicals in a cyclical assessment of the asset class. Entry points for emerging assets are currently favorable in our opinion.
After three difficult years for EM assets, EM yields are close to their pre-2007 levels of about 5.5%–6.5%, while DM yields are mostly trading at negative yields or are at historical lows. In fact, with over $11.7 trillion worth of DM debt trading at negative yields, one could argue that EM valuations are less distorted and embed much more risk premia than developed market assets.
Emerging markets also offer more value relative to developed markets after adjusting for credit quality. In hard currency space, our analysis of the fundamental risk of default for the asset class suggests that in the majority of cases, emerging market risk premia compensates investors for the risk of default.
Market technicals in emerging assets are also a lot cleaner. The tremors in EM since 2013 have cleared much of the hot retail money out of the asset class, which reduces the risk of panic selling during periods of market turmoil. At the same time, long-term strategic mandates remain invested and are opportunistically increasing allocations. Global flows into EM debt are just now turning moderately positive compared with historical flows, in spite of the strong rally in emerging debt so far this year. Add to this the decline in net issuance in EM hard currency space, and supply technicals look better particularly relative to prior years when high net issuance in the corporate space was a headwind for spreads. In local space, a key supporting factor has been the increasing role played by domestic investors as local pension and institutional assets have grown, leading to increased onshore investment. This has enabled a more balanced technical position between locals and foreigners and provides an important countercyclical anchor for local yields. We saw the impact of this development very clearly in the orderly retreat of foreign ownership of local bond markets in emerging Europe and Lat Am over the last few years.
But what should we make of the greater volatility of EM investments and potential for losses? Our sense is all that is currently needed for EM to do well is stabilization in the global and domestic backdrop, not necessarily a significant improvement. This is because valuations have priced in a lot of the downside, fundamentals within EM are improving and EM currencies have depreciated significantly and in many cases look cheap.
Also, Fed normalization, if accompanied by U.S. and EM growth, would not necessarily be a bad thing for risk assets. In contrast to the panic and negative sentiment seen during the Taper Tantrum, when markets were expecting the Fed to make a hawkish mistake, the Fed’s dovish and slow but steady stance on the rate cycle has now been widely telegraphed.
Moreover, from a total return perspective, the carry cushion in EM bonds relative to DM means that the hurdle rate is high to underperform over the long term, particularly when the starting point is cheap valuations. In hard currency space over the next five years, the JPMorgan EMBIG bond index (yielding 5.4% yield and a spread of 394 basis points versus U.S. Treasuries at the end of July) would need to widen to 615 bps – and stay there – for investors to have negative returns versus investing in U.S. investment grade (IG) (see Figure 4). For context, JPMorgan EMBIG spreads averaged more than 650 bps during the height of the Lehman crisis.
Compared to U.S. HY, emerging markets have a slightly lower spread cushion, but adjusted for volatility, our expectation is that EM returns present a compelling alternative to sub-IG corporate credit risk over the next 12 months (see Figure 5). Moreover, while asset classes like U.S. HY may also benefit from negative yields in developed markets, it is worth noting that the size of the flows from DM dwarfs HY assets under management, suggesting spillovers to other asset classes are very likely. In addition, HY may face lower liquidity and higher gating risks than EM hard currency funds.
Meanwhile in local space, EM currencies have adjusted by 30%–40% in nominal terms since 2013 and in several cases look to have overshot fundamental fair value. Real yield differentials versus DM have widened, while EM-DM nominal yield differentials are close to all-time highs. This combination of high yields and cheapened currency valuations provides an important carry cushion for investors and suggests the hurdle rate to lose money on EM local investments is high over a secular timeframe. Indeed, if one buys a 5-year Brazilian bond today yielding ‒11.90% and holds it to payment at maturity, it would take a 40% devaluation of BRL to lose money (see Figure 6). The power of this high carry compounded over time can potentially be significant. Since 2007, emerging market assets have returned double-digit returns despite the last several years of volatility, with EM hard currency assets (proxied by the JPMorgan EMBIG Index) returning a cumulative 96% and EM local assets (proxied by the JPMorgan GBI-EM-GD Index) returning a cumulative 52% (as of 31 July 2016).
The case for optimism
The combination of improving EM fundamentals and valuations alongside simmering and sporadic exogenous and endogenous risks warrants a strategically sanguine approach to investing in emerging assets. We see opportunities in both hard currency and local markets for investors looking to increase structural allocations to the asset class. In the external space, investment themes we favor include idiosyncratic credits in the process of healing, short-dated positions where carry and roll-down is attractive, and improving credit stories with potential for upgrades and spread compression.
In local markets, we are focusing on front-end rates of countries with higher-yielding bonds and in which inflation dynamics are improving, central banks are in easing mode and rates are anchored by the low-for-longer global yield outlook. We also see value in longer-dated instruments in “low yielders” whose credit stories are solid and whose central banks are managing well the disinflationary impulses emanating from the developed world. On the FX side, in spite of cheapened valuations, we are more selective and maintain both long/short EM exposures versus a more neutral overall USD position.