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Emerging market fixed income – the outlook

Investment strategy

Bryan CARTER
 

While hard currency debt will continue to offer good income potential, higher defaults and valuations should limit capital appreciation. Local currency EMD should benefit both from currency appreciation as well as from local EM bond yields remaining lower for longer.

  • Despite a sometimes challenging environment, emerging market debt generated strong returns in 2019
  • Double-digit returns for all four principal EMD categories, led by hard currency debt

Exhibit 1: Returns for the different categories within emerging market fixed income (EMFI) in full year 2019

EMFI 2020 Jan 1

Past performance is not indicative of current or future performance. Source: JPMorgan; 2019

2019 saw headlines on looming debt defaults from Argentina to Lebanon. Protests in countries as disparate as Hong Kong and Bolivia raised concerns among investors over investment risk.

In addition, the bonds of several countries including Ecuador, Tajikistan and Zambia now trade, rightly or wrongly, at distressed levels. In short, during a year of strong returns, we saw extreme dispersion at the country level with emerging market debt markets.

Exhibit 2: Hard currency EMFI: Top & bottom performers – full year 2019

EMFI 2020 Jan 2

Past performance is not indicative of current or future performance. Source: JPMorgan; 2019

Exhibit 3: Local currency EMFI: Top and bottom performers – full year 2019

EMFI 2020 Jan 3

Past performance is not indicative of current or future performance. Source: JPMorgan; 2019

In 2020, we expect a broadly supportive environment for EMD investments, albeit with considerable country dispersion.

EM sovereign default rates will continue to rise in 2020 with a bunching of risky debt maturities being reached this year. Dispersion is typically a positive dynamic for active managers, although it is striking that most active managers underperformed the major EMD benchmarks in 2019. Choosing the right manager has and will become ever more important, in our view.

We believe our close focus on assessing issuers on the basis of strict environmental, social and governance (ESG) criteria will continue to help protect investors from pitfalls and produce long-term sustainable returns. This, combined with a marriage of top-down asset allocation and bottom-up credit screening, defines our incisive investment process.

Our forecast for EMFI returns in 2020

Calendar year 2020 Income assumption Returns from

duration

Returns from currency Total returns

(with alpha)

Hard currency EMFI strategy 5.2% 1% 0% 6-7%
Local currency EMFI strategy 5.2% 0% 4% 9-10%
EMFI total return Strategy 5.2% 1% 4% 10-12%

 No assurance can be give that any forecast, target or opinion will materialise. There is no guarantee that the performance objective will be achieved. Source: BNPP AM, 2019

Macro-economic outlook: Expect strong US/weak EM cycle to reverse in 2020

We see the global cycle as being an important inflection point now. Over the past few years, we have witnessed a period of stronger US growth amid a downturn in the rest of the world, including emerging markets.

In 2020, we expect this trend finally to reverse, with the US slowing as fiscal stimulus subsides and politics dominate during a contentious general election cycle.

On the other hand, we expect various emerging market economies to start benefiting from considerable monetary – and in some cases fiscal – stimulus, and for growth to rebound from relatively subdued levels.

In addition, as Chinese economic data has continued to soften, we expect policymakers to employ targeted stimulus to support the domestic economy, and by extension, the broader Asian and EM complex.

Exhibit 4: Estimated real GDP growth (year-on-year)

EMFI 2020 Jan 4 

Past performance is not indicative of current or future performance. Source: JPMorgan, UBS, Bank of America, Goldman Sachs, Citigroup, Morgan Stanley, BNPP AM; 2019

The key risks to our theme include:

Financial sector risks as leverage and imbalances grow in the developed world

  • Inflationary shocks which could force central banks to adopt a more hawkish monetary policy response
  • Re-escalating global trade tensions which could further suppress global trade, disrupt global supply-chains and lead to capital flight out of EM

Hard currency EMD to offer stable returns in line with yields

  • Demand side technicals remain supportive as low global yields drive inflows
  • Pockets of value remain, especially relative to developed markets, in the non-distressed higher yielding segment
  • Expect EM sovereign default rates to rise from current low levels

While hard currency EMD will continue to offer good income potential relative to developed markets, higher defaults and valuations near fair value will limit capital appreciation here.

Local currency EMD offers strong return potential via currency appreciation

  • EM central banks to retain a dovish monetary policy stance on account of benign inflation pressures and low growth
  • A US Federal Reserve on hold should also provide EM central banks with more policy manoeuvrability
  • EM currencies poised for a rebound in line with growth and investment cycles

In our view, local currency EMD should benefit both from currency appreciation as well as from local EM bond yields remaining lower for longer. This leads us to believe there are good prospects in 2020.


This article appeared in The Intelligence Report

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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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