Is It Time to Wade Back into Emerging-Markets Debt?
There are at least two reasons why emerging-markets debt is looking up, though investors should still be a bit cautious.
After years of languishing for attention, emerging-markets debt is back on the investment radar. The skepticism over how long the asset class will sustain its momentum is understandable. Is now indeed the right time to get back in?
It is still early days, but there are at least two reasons to suggest there are rewards to be had for reentering emerging-markets debt.
First, the investable universe of emerging-markets debt is steadily expanding. A large component of emerging-markets debt volume used to be bank financing, much of which has since been refinanced through bonds, which has added to debt levels.
The market is also supported by a few technical factors that are helping to underpin pricing. There has been very little issuance of emerging-markets corporate bonds so far this year, resulting in a shortfall of new supply when compared with amortizations and coupon payments. That’s good news for investors in the near term, as scarcity drives up prices. That said, the magnitude of emerging-markets debt that’s due to mature in 2017 makes this scenario more concerning over the long term. The fact that issuers are not refinancing before this looming rise adds uncertainty to the markets; therein lies the paradox of limited supply.
Nevertheless, we are more comfortable than not with emerging-markets corporate debt at this stage. We see fundamentals stabilizing from a low level, and many indicators for the economy are bottoming out. The environment for businesses across emerging markets has been improving. Credit metrics for corporates are growing healthier. Valuations are less challenging, as spreads have compressed but are still wide, relative to their five-year average.
The second reason to take another look at the asset class involves relative value.
As a result of negative interest rate policies in Japan and in much of Europe, today more than one quarter of the world’s government bonds are guaranteeing a fixed loss for investors holding to maturity, and more than half of the developed world’s global government bonds are trading on yields of less than 1 percent. Put another way: Of the $44 trillion in assets reflected in the global aggregate bond index, 20 percent is trading at negative yields.
The extraordinarily low yields on core government bonds across developed markets continue to hinder the hunt for income. By comparison, emerging-markets debt yields look generous on a relative basis. At J.P. Morgan Asset Management, we predict that investors will increasingly seek out emerging-markets debt to help fill this unsustainable yield gap.
We see signs of stabilization that bode well for emerging-markets debt in the near term, particularly in regions such as Latin America and Central Europe, where macro indicators are bottoming out and retail sales and investment activity are solidifying. We expect economic growth across emerging markets to average a respectable 4 percent over the next quarter. We see a bit of a muddle-through scenario for emerging-markets debt: There is likely not only little threat of developed-markets growth overheating and prompting inflation but also a good chance of avoiding any damaging recession risk.
Although China continues to face significant challenges, we have a relatively benign view of the country’s economy. China has implemented strong easing policies, shored up its currency and established real estate policies to cool its property market. All of those measures suggest a more favorable medium-term outlook, although we will continue to monitor progress with structural reforms and accumulation of foreign exchange reserves.
So what does this all mean for emerging-markets debt? Given the downside risks, we’re still a bit cautious. From a tactical standpoint, however, it looks like a good time to be invested across the asset class. One potentially complicating headwind is fiscal deterioration in commodities-exporting countries. Another is inflation, where we see significant differentiation among countries. These factors underscore the importance of a selective investment approach.
In our view, the winners of the emerging-markets debt trade stand to be countries such as Morocco and the Philippines, as well as those in Central Europe, where investors are well compensated and the economy is supported by strong fundamentals. We also currently like the valuation opportunity in selective parts of Latin America and some idiosyncratic high-yielders, such as Argentina and Brazil.
Our top investment idea at J.P. Morgan Asset Management has been to increase duration in sovereign-dollar debt, which at approximately six years currently is near a record high in our emerging-markets debt portfolio. We think duration will be a major beneficiary of the continued search for yield. We’ve also tactically increased our currency exposure to capitalize on the carry opportunities.
Returning flows should support pricing, and limited supply is creating scarcity. Investors would be well served to proceed with caution, but the sun may be shining again for emerging-markets debt.
Pierre-Yves Bareau is chief investment officer for emerging-markets debt at J.P. Morgan Asset Management in London.