Clearly, emerging markets have had a challenging year in 2018. Headwinds from tightening global financial conditions have played out against a backdrop of US trade tariffs and idiosyncratic risks in emerging markets. However, while global growth improved, the growth difference between emerging markets and the US shrank. Taken together, these factors have served to weigh on emerging market debt. Emerging market corporate debt has generally held up better than sovereign debt, partly reflecting its better credit quality and lower duration. In addition, arguably the greater resilience of the asset class also helped. It is more exposed to emerging market countries with a higher contribution to global growth and less exposed to more vulnerable frontier markets.
Looking ahead, we expect some of the headwinds – trade tariffs, overlaid with a late-stage developed market cycle, tightening US dollar liquidity and moderating US growth – to continue. Ultimately, we expect emerging market fundamentals to prove resilient. Valuations point to a significant deterioration in overall credit quality, more consistent with a global recession than a softening of growth.
While emerging market growth may have disappointed expectations, 2018 has generally delivered solid corporate growth. Although currencies have weakened against the US dollar, companies have been able to pass on most of the rise in input costs to customers, balancing price increases with protecting volumes. As such, margins remain healthy, especially for exporters and those companies with US-dollar linked revenues. Overall, earnings remain robust.
Despite this, most emerging market corporates have operated with one eye on the rear-view mirror, mindful of the downturn in 2013-2015, while navigating changing political landscapes, deteriorating global trade relations and, in some cases, currency crises. This has resulted in relatively muted expansion plans, with generally light capital expenditure and continued financial prudence leading to asset sales, debt reduction and equity raising to maintain healthy debt levels.
This general conservativeness has reinforced the resilience of those companies operating in more fragile economies, such as Argentina or Turkey. 2018 has proven to be a year of low default rates and we expect this trend to continue into 2019. Credit rating agencies are increasingly acknowledging the resilience of emerging market companies. We see increasing divergence between government and corporate ratings, as companies manage their debt conservatively while diversifying their earnings and geographic locations.
Figure 1: Low default rates likely to continue
Source: BoA Merrill Lynch, 30.09.18.
For 2019, we expect emerging market growth on balance to remain stable, with some downside risks of a softening in demand. However, given the now relative cheapness of emerging market currency real effective exchange rates (REER), we see an attractive landscape for a large portion of emerging market corporates to continue to benefit. Baseline economic growth expectations remain supportive of continued revenue growth, with margins likely to stabilise.
However, we believe it will be a year of differentiation, as emerging market currency devaluations tighten domestic credit conditions, and the impact of trade tariffs filters through. It’s also becoming less clear how long US growth will continue, leading to uncertainty over the extent of central bank rate rises. The speed of quantitative tightening adds an extra variable at a time of plentiful US Treasury issuance. These risks, alongside potential policy mistakes, suggest that caution is warranted. This base case should support credit markets by keeping US Treasury yields contained, allowing for a weaker US dollar, while providing ample global economic growth and less restrictive financial conditions to support both emerging market and US credit spreads.
China’s economic policy will also be a significant driver of returns in 2019. We expect recent stimulus to have a widespread economic effect, helping to mitigate the impact of trade tariffs and stabilise growth. However, tentative signs of a property price correction suggest the risk of a broader slowdown, given the government’s focus on rebalancing the economy away from housing-related investment. Thus, we remain vigilant observers of Chinese property prices and consumer sentiment.
We believe the inclusion of China into the Bloomberg Barclays aggregate indices will have a positive impact on investment and growth in 2019, but obstacles remain. Overall, we expect Chinese growth to steady, but acknowledge the potential for a slowdown in growth to permeate across wider markets, with frontier markets the most vulnerable.
The expected general easing of growth should support fixed income assets over equities. Our base case is for a gentle moderation, rather than a broad policy-induced contraction, which suggests emerging market assets will perform well.
While risks exist, emerging market corporate fundamentals remain impressively robust, with expected low defaults to continue through 2019. However, valuations have priced in significant stress for many corporates. With the outlook for global growth still uncertain, we expect volatility to remain.
In a world of stronger growth, we expect significant spread compression, particularly in high yield bonds, while we acknowledge that slower growth should see investment grade bonds outperform. However, the reality is that across countries and ratings, differentiation of credits exists. The asset class remains diverse enough to navigate either scenario and deliver excess returns above the yield. Much of the asset class has excessive risk premia which should subside once visibility improves, potentially leading to strong returns from the asset class in 2019.
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