Emerging Markets Look Forward to 2019
December 17, 2018
After a challenging year for risky assets, in emerging markets (EM) fixed income in particular, we hold a constructive outlook for 2019, driven by attractive valuations, a benign global backdrop of moderate growth/subdued inflation and a U.S. Federal Reserve Bank (Fed) that is likely approaching the end of its tightening cycle. We believe these factors and growing twin deficits in the U.S. limit the scope for material U.S. dollar appreciation, further supporting EM fixed income assets.
Local currency strategies should benefit from already adequately tight monetary policy in key EM economies, and steep yield curves providing investors with excess term premium. Among credit, the JP Morgan Emerging Markets Bond Index Global (EMBIG), a proxy for U.S. dollar external debt, screens as cheap versus both its historical average and traditional comparables such as U.S. high yield. The same holds true for the JP Morgan Corporate Emerging Markets Bond Index (CEMBI), a proxy for U.S. dollar corporate debt, where absolute and relative spreads have sharply underperformed other credit markets such as U.S. and European high yield in 2018, despite generally improving fundamentals that are reflected in a similarly (low) default profile.
A stable-growth/moderate-inflation global backdrop supports EM assets
Our global outlook for 2019 is one of moderation both on the inflation and growth fronts.
Continued monetary policy normalization and declining oil prices underpin our subdued global inflation outlook. We expect a similar picture of anchored and moderate inflation in EM, barring some idiosyncratic cases.
We also envision slowing global growth, primarily in developed markets (DM), on the back of diminished policy support. Meanwhile, EM should reinforce our moderate growth/subdued inflation thesis, mainly driven by weaker Chinese growth. However, there is dispersion within EM: several key countries are starting to recover, and barring negative shocks, should continue their upward march toward potential growth. We thus expect EM-ex-China growth to stage a mild recovery, which may bode well for EM debt assets, as suggested by a historical analysis of EM debt returns as seen in Display 1.
Finally, a context of softening U.S. growth and subdued inflationary pressures, as well as unsteady U.S. stock and housing markets, significantly undermines the case for further Fed hikes beyond current market pricing. Confirmation of our thesis, and its corollary of potential U.S. dollar weakness next year, should bode well for EM assets. Our analysis suggests an overvaluation of the USD in real terms of approximately 10 percent which strengthens our view of a weaker dollar in 2019.
EM-ex-China at recovery stage: good for EM fixed income
To help inform our views on EM debt assets for the year ahead, we examined the historical performance of bonds, rates and stocks in EM at each stage of the business cycle, which we identified as follows: recovery, expansion, slowdown and contraction. Our output gap calculations indicate that EM-ex-China is currently in the recovery stage of the business cycle, and to the extent that historical performance provides useful information about future return potential, the analysis supports our constructive thesis for EM: all EM debt strategies have posted positive returns during the recovery phase, though they have failed to outperform EM equities.
All metrics agree that EM sovereign spreads offer value
All valuation metrics we reviewed suggest there is value in sovereign spreads: EMBIG spreads look about 50 basis points cheap to their 10-year historical average, and the Bloomberg Barclays U.S. Corporate High Yield Index-EMBIG spread differential is at all-time lows, despite the higher average credit rating of EM spreads. Furthermore, our fair-value sovereign spread model, which relates spreads to fundamental domestic and external variables, suggests that spreads are cheap by about 40 basis points. The model also points to cheapness in Africa and, to a lesser extent, Latin America, while flagging European sovereigns as expensive and Asian spreads as fairly priced. At the country level, we like Indonesia, Ukraine and South Africa (conditional on a positive election outcome), while we remain cautious in Turkey and Mexico.
Value in local rates on high EM-DM real rate gap, steep curves, amid U.S. dollar weakness
EM real rates still look compelling, at 2 percent levels, and similarly the real yield differential with DM remains attractive at ~300 basis points. We expect real rate differentials to remain at elevated levels next year as Fed Fund rates get closer to neutral, other DM Central Banks cautiously remove monetary stimulus, global inflation remains subdued and EM Central Banks keep tight monetary policy stances. In addition, sizable steepness in several EM curves offer attractive opportunities for extending duration (for example, in Peru and Brazil), while we avoid long-duration positions in Mexico, given heightened policy uncertainty.
Valuations in EM corporate debt look favorable relative to default expectations
We see the sharp correction of EM corporate spreads, particularly in high yield, since the turn of 2Q18 as excessive given our assessment of credit fundamentals. Our confidence in EM credit is grounded in improving metrics (credit, management actions, etc.). The improvement has been supported by the behavior of EM corporates since the end of the global financial crisis. These improvements are best illustrated in default expectations, which now look likely to end the year well below the 2.5% forecast we set at the beginning of the year in spite of the rise in idiosyncratic negative developments in countries such as Argentina and Turkey.
Looking ahead to 2019 we view the spread widening of EM high yield as particularly noteworthy given expectations that default rates in EM will likely remain low and in line with U.S. high yield next year. In investment grade credit, we also believe the weakness in spreads is somewhat counterintuitive given fundamental improvements in EM credit quality (which should continue to see upgrades outpace downgrades over the coming 12-18 months), versus in the U.S., where the combination of debt-financed stock buy-backs, and merger and acquisition (M&A) activity may put pressure on credit ratings in 2019.
There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks.
Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest-rate environment, the portfolio may generate less income. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities (“junk bonds”) are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging-market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).
1 “Revisiting Our Emerging Market Sovereign Spread Valuation Framework,” Emerging Markets Debt Team, Investment Insight, 2018.
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