December 18, 2019
2020 Emerging Markets Debt Outlook: Differentiation over Duration
December 18, 2019
In our view, stabilizing but still subpar global growth will reign in 2020. Our baseline scenario envisions a global economic backdrop only marginally better than in 2019, thus leaving global monetary policy accommodation largely in place. Though we expect widening emerging market (EM)-developed market (DM) growth differentials to support EM assets, we expect EM fixed income to deliver more subdued returns relative to this year, given our views on current valuations and limited scope for aggressive monetary policy accommodation in the developed world.
In local rates, we see the most attractive opportunities in countries displaying disinflationary or stable inflation dynamics, and offering generous real rates. Emerging market currencies, relative laggards versus the U.S. dollar in 2019, could also offer value. However, we believe FX opportunities may arise in currencies of economies experiencing cyclical rebounds and showing robust external accounts. In hard currency debt, valuations are less appealing, with limited opportunities in investment grade and more value in high yield sovereigns.
As for EM corporates, we see the benign macro outlook as supportive of credit fundamentals, with the financial discipline practiced by EM companies’ managements leading us to expect default rates to remain limited and idiosyncratic. As such, we believe there will be interest to return to high yield at the expense of investment grade credit and higher quality duration, which was very much the market’s focus in second half of 2019. We think that, on balance, risks are skewed to the downside, given the optimism already priced in on trade issues, and heightened and increasing social tensions in EM economies, which could give rise to populism and a deterioration in economic policymaking.
Stabilizing but still subpar growth requiring continued loose monetary policy.
Next year’s consensus view on the global economy envisions a more benign growth environment, as both easing trade tensions and a reduction in political risks provide a more constructive backdrop for trade and investment flows. Better growth prospects could lead to a moderate steepening of developed market yield curves, whereas a slowing U.S. economy relative to the rest of the world could ultimately weaken the U.S. dollar. Under this scenario, growth sensitive emerging market assets, such as equities, FX, and high yield credit should outperform, while investment grade credit and long duration local rates would suffer.
Even though we see merits in that view, we are not as confident as the market about its likelihood, or the expected positive global growth effects from easing trade tensions. We are skeptical that a “Phase 1” trade agreement would reduce uncertainty significantly enough to boost trade and growth materially. First, it remains to be seen whether such a limited trade deal would include a rollback in tariffs already in place. In addition, enforcement of any deal would probably require the threat of tariffs, thus discouraging business investment. Any positive effect stemming from a partial trade deal could be offset by other forces weighing on investment; in particular, U.S. elections featuring multiple candidates with diverse views about economic (particularly, fiscal) policy. Finally, we believe that the U.S./China conflict goes beyond trade disputes and includes China’s development model, and competition in the technology and military fields, over which we see no willingness by either party to compromise. Moreover, U.S. views vis-à-vis China transcend the domestic political divide, with a potential Democratic-led government likely adopting a similarly tough stance on China.
EM growth across regions will likely be uneven, a function of different initial conditions, regional context, and idiosyncratic factors. In Asia, we see China’s growth slowing down to slightly below 6%, whereas countries in Asia-ex China may mildly rebound on the back of monetary stimulus, fiscal easing (most notably, Malaysia and Indonesia) and some stabilization in trade flows, provided no worsening of U.S./China trade tensions. In Latin America, the Andeans and Mexico are now in a better position to address growing social demands after years of weakening growth and rising inequality in the region, while Brazil is one of the few economies that stands out for its commitment to reforms that could boost growth and strengthen the economy. We see the Andeans (excluding Chile) continuing to outperform the rest of LatAm but still growing below potential, with Brazil and, to a lesser extent, Mexico experiencing a mild cyclical pickup in economic activity from very low levels in 2019. The solid-growth economies of Central and Eastern Europe should slow down to levels more in line with potential, whereas Turkey is expected to rebound from likely negative growth on the back of monetary stimulus and other heterodox polices, at the risk of jeopardizing recent gains in macroeconomic rebalancing. Finally, in Russia, growth prospects are expected to improve, on the back of a more effective implementation of infrastructure spending and monetary policy easing.
Despite continued loose monetary policy, opportunities in Emerging Market fixed income are not as plentiful as in 2019.
Our view of marginally improving, but still subdued, global growth next year is consistent with persistent global monetary policy accommodation. However, we see limited scope for monetary policy to turn more lax, as many developed market central bank rates are at or below zero, and with aggressive quantitative easing policies already in place. As a result, owning duration is unlikely to deliver as strongly in the coming year, which would demand a more selective approach to investment opportunities in EM debt.
EMFX offers value, on the back of a widening EM-DM growth differential, and conditions for dollar weakness to eventually materialize next year, but we think opportunities may be restricted to countries featuring solid external balances and improving growth, such as the Russian ruble and the Brazilian real. In local rates, we see the most attractive opportunities in countries with subdued inflation and generous real rates (Russia, Indonesia, and Mexico) or implementing reforms that could cause risk premiums to compress (most notably, Brazil). In hard currency debt, valuations are less convincing after a solid performance this year, with limited opportunities in investment grade and potentially more interesting alternatives in high yield sovereigns undergoing structural reforms, such as Ukraine, Egypt, or Angola. We will also monitor countries currently undergoing political transitions such as Sri Lanka and Argentina, but we remain sidelined for the time being, awaiting more clarity on politics. Extending our macro views to the private sector, our outlook for EM corporates looks similar to that of last year. Fundamentals should remain underpinned by the combination of flat to improving macroeconomic conditions and financial discipline that has seen companies proactively managing their liabilities in the current low rate environment. This should continue to anchor credit risk and maintain default rates in the low single digits in 2020 and favors high yield credit over investment grade duration. Our only caveat would be the tightening of financial conditions we have observed for the lower end of the high yield market, which represents a downside risk to our benign view for defaults more generally. Regionally, we see developing risks in Latin America dulling the shine that supported its relative solid performance in 2019, with any rotation benefiting EMEA, supported by demand technicals, and more so, Asia, should we actually see real progress on trade.
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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 a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Foreign securities are subject to currency, political, economic and market risks. Longer-term securities may be more sensitive to interest rate changes. 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. 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. 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).
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