By Peter Eerdmans, Co-Head of Emerging Market Fixed Income
Emerging market debt (EMD) has suffered a challenging couple of months, with yields, spreads and currencies all coming under pressure. While the sell-off has been material, we see this as a mid-cycle market correction, given the constructive global growth backdrop and the still considerable slack in emerging market economies. We thus think the weakness is generating opportunities and providing an attractive entry point for investors looking to make a structural allocation to the asset class.
A mid-cycle market correction
The 2013 taper tantrum and the bear market that continued through to 2015 were driven by poor and deteriorating EM fundamentals, and historically tight valuations. By contrast, the current sell-off in EMD comes at a time of strong global growth, strong and improving EM fundamentals and attractive valuations Therefore, we believe it makes more sense to compare this sell-off to the 2004-2006 period when the US was relatively late in the economic cycle, the US Federal Reserve (Fed) was tightening and EM fundamentals were relatively robust. During this period the Fed hiked rates a cumulative 4.25% from 1% in the summer of 2004 to 5.25% in the summer of 2006. Importantly, the global economy was booming, not just the US, and EM growth was outperforming its developed market (DM) peers. Thus, over the same period as the US rate sell-off, EMD rallied strongly, with both local currency and hard currency EMD up over 10% annualised over the hiking cycle.
Figure 1: EMD performance during 2004-2006 Fed tightening cycle
Source: Investec Asset Management, Bloomberg, JP Morgan. Period corresponds to start and end date of Fed hiking cycle in this period.
The market corrected several times during this multi-year EMD bull market. While all of the sell-offs had their own idiosyncrasies, some common themes emerged. In particular, the sell-off in EMD occurred after, or in concert with, an accelerated pace of US Treasury weakness, global equity volatility and dollar strength versus other developed market currencies.
The current market correction shares some elements with these historic market corrections:
- The global economy is going through an expansionary phase – indeed its most consistent period since the 2008 financial crisis – and the EM growth differential is widening over its DM peers.
- The US rate sell-off had accelerated in the prior months to the sell-off and the US 2-year Treasuries continued to move up meaningfully during April and into May.
- As part of the broader market correction equity volatility increased in recent months – not just EM, but also the S&P sold-off sharply from overbought levels.
- Dollar strengthening has been broad and not confined to EM.
Figure 2: EM local currency market corrections during Fed tightening cycle
Source: Investec Asset Management, JP Morgan. 16 April to 8 June 2018.
Generally positive outlook for EMD
While there might be further near-term headwinds, we expect EM assets to start outperforming, as the investment case remains compelling:
A constructive backdrop
The global growth cycle remains relatively strong. EMD performs best when the global economy is doing well – better still when the rest of the world is outperforming the US. Part of the reason for the sell-off in EMD has been the softening of global data (particular European) versus the US in recent months. We think this will likely revert in the coming months, given the slack in much of the rest of the global economy compared to the US.
While global monetary conditions are tightening, this does not preclude strong EMD performance, as Figure 1 shows. Sell-offs tend to occur during, or in the aftermath of, periods of accelerated rates tightening, such as we have seen over the last few months. With over two rate hikes now priced for 2018 in the front end of the Treasury curve and the 10-yr arguably much closer to the terminal Fed funds rate, we think we’ll see a much more modest pace of US tightening from here. At the same, our base case remains that European Central Bank unwinding will be a long drawn out process.
The dollar still looks expensive relative to history, with real effective exchange rate (REER) valuations in particular quite stretched. This is linked to the extended US business cycle, now likely long in the tooth. More structurally, the USD needs to adjust downward over the medium term, due to the large build up in the country’s net liabilities over the two decades – around 40% of GDP.
EM economies are growing at a relatively strong pace. The growth differential over developed markets is widening and should continue to widen over the medium term, given the slack in EM economies.
Likewise, EM current account balances are in a much stronger position than in 2013, with 15 having moved from deficits to surpluses in many cases (Figure 3), and recent improvements to terms of trade continues to favour EM.
Figure 3: EM ex-China current account balance
Source: Investec Asset Management, Haver May 2018. Data up to Q1 2018. GD-weighted current account balance
EM inflation is contained (Figure 4) and has continued to surprise to the downside, with a relatively benign outlook for most markets (albeit risks to the upside in oil importers). With most emerging markets still early in the cycle, considerable slack remains in their economies. This provides room for further growth upside without driving inflation or worsening of trade balances.
Figure 4: EM CPI inflation: HY vs LY
Source: Investec Asset Management, Haver. June 2018. Quarter on quarter, JP ELMI+ weighted inflation between High Yield and Low Yield EMD.
Valuations remain attractive
Given, the fundamentals we feel the recent weakness merely enhances valuations in the asset class.
On the currency side, EM REERs remain around 15% below the pre-taper tantrum high. Over the short-term, EM currencies and terms of trade have diverged significantly over recent weeks. We think this should support EM spot appreciation over the coming months to close this gap (Figure 5).
Figure 5: GBI-EM terms of trade vs GBI-EMFX
Source: Investec Asset Management, June 2018
As for local yields, the GBI-EM yield has backed up around 50bps to 6.5% – bang in the middle of its five-year range. The yield premium over DM is now close to 5% versus global government debt (JP Global Bond index). With EM yields largely pricing in modest hikes and inflation contained, it is difficult to see how much further EM local yields can back up from here. The real yield differential is close to five-year highs (Figure 6).
Figure 6: EM vs DM real yield
Source: Investec Asset Management, June 2018
Credit spreads have also backed-up, offering a better entry point to the asset class. This is particularly true as we are still early in the cycle with improvements in credit fundamentals (growth, external and fiscal improving in most markets), only now starting to reflect in credit rating action (Figure 7).
Figure 7: Sovereign credit rating momentum
Source: Investec Asset Management, June 2018. Up to Q1 2018
Conclusion: potentially attractive entry point
We view the recent sell-off in EMD as more of a mid-cycle market correction than the start of a bear market. The global economy is growing at a healthy pace, EM fundamentals are strong and improving and valuations are compelling. This offers a potentially attractive entry point for investors looking to allocate to the asset class.
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