CONTRIBUTORS
Kevin J. Ritter, CFA
Robert O. Abad
After a strong beginning to the year, emerging markets (EMs) find themselves once more entangled in the web of US interest-rate swings and a robust US dollar (USD). This time, the rise in yields is linked to concerns over the US budget deficit and increased issuance of US Treasury (UST) bonds, which are intended to cover exceptional expenditures associated with the Inflation Reduction Act, student loan forgiveness and the shortage in capital gains tax revenues. The steepening of the UST yield curve and strengthening of the USD since early August, driven by concerns of a “higher-for-longer” rate environment, have raised worries about the future performance of risk assets, including EM debt.
In our view, the EM story remains compelling. First, economic data in developed markets (DMs) continues to support our base case of moderating global growth and decelerating inflation, which should benefit EM fundamentals. Second, EM central banks are nearer to the end of their tightening cycles compared to their DM counterparts, which should boost demand and performance for local bonds in EM countries considered “first hikers.” Third, the possibility of the Fed pausing its rate hikes, combined with ongoing economic stabilization in China, could significantly improve EM sentiment and asset prices.
It’s worth noting that over the past five years, EMs have experienced three material downturns, with two of them linked to Fed actions. Exhibit 1 highlights this trend, illustrating how EMs (with the exception of the corporate segment) had tended to be more vulnerable than other fixed-income asset classes to macroeconomic factors like growth differentials, monetary policy and geopolitics.
Exhibit 1: Emerging Market vs. Developing Market Index Returns
Source: Bloomberg. As of September 30, 2023. EM Local is represented by the J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Index, which tracks local currency bonds issued by emerging markets. EM $ Sov is represented by the J.P. Morgan (JPM) Emerging Markets Bond Index (EMBI) Global Diversified Index is a uniquely weighted version of the JPM EMBI Global Index, which tracks total returns for U.S. dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady bonds, loans and Eurobonds. The index includes all countries except those that have been classified by the World Bank as high income for the past two consecutive years. The diversified index limits the weights of those index countries with larger debt stocks by only including specified portions of these countries’ eligible current face amounts of debt outstanding. EM $ Corp is represented by the J.P. Morgan Corporate Emerging Markets Bond (CEMBI) Broad Diversified Index, which is a modified market capitalization-weighted index designed to measure the performance of the US dollar-denominated emerging market corporate bond market. US Agg is represented by the Bloomberg US Aggregate Bond Index, which is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States. US Credit is represented by the Bloomberg US Credit Index, which measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government-related bond markets. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
Looking forward, we acknowledge that the EM asset class is vulnerable when considering two possible extremes: continued US exceptionalism characterized by stronger growth, higher inflation and higher rates, or a protracted US recession that could lead to increased credit risk and default risk premiums. Either of these extreme scenarios could impact the outlook for EM valuations. Exhibit 2 illustrates how EM investment-grade debt is currently trading at historical narrow spreads relative to US investment-grade debt due to supply dynamics, while EM high-yield debt warrants close monitoring after substantial underperformance compared to US high-yield debt in 2022.
Exhibit 2: Emerging Market Spread Premium Over US Credit
Source: Bloomberg. The Bloomberg Emerging Market Index is a rules-based, market-value-weighted index engineered to measure USD fixed-rate sovereign and corporate securities issued from emerging markets. The Bloomberg US Corporate High-Yield Index measures the USD-denominated, high-yield, fixed-rate corporate bond market. As of September 30, 2023. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
That stated, we currently see local markets and frontier markets as two areas within the broader EM asset class that offer an attractive combination of high carry and total return potential. Here’s a summary of our views:
Emerging market local markets
Our focus is on countries with elevated real interest rates, a promising growth outlook and plans to cut rates in the near term.
Mexico (Baa2/BBB/BBB-)
- Disinflationary trends bode well for the economy; a new administration in June 2024 paves the way for more market-friendly policies.
- The central bank is expected to keep rates higher for longer, which makes the local rates carry and Mexican peso trade compelling.
India (Baa3, BBB-/BBB-)
- A strong economic story supported by robust foreign direct investment flows (on increasing friendshoring benefits) and significant foreign exchange reserves (in the top five globally).
- Local bonds and the Indian rupee are expected to outperform given attractive carry relative to peers and strong technical tailwinds associated with EM bond index inclusion.
Brazil (Ba2/BB-/BB)
- Recently upgraded by Fitch, persistent economic resilience even under the leadership of seemingly “leftist” President Luiz Inácio Lula da Silva administration.
- The monetary easing cycle has started making rates attractive; meanwhile, still-high nominal and real rates are expected to support the Brazilian real.
Frontier markets
We find the risk/reward profile of frontier market debt appealing. Compared to EM investment-grade and US high-yield, valuations in this sector are notably wide from a historical perspective. This makes sense, to some extent, given frontier economies’ relatively elevated sensitivity to external financial conditions, which have presented a constraint for most of the past three years. Yet frontier markets are also a diversified subset of the broader EM universe. In many cases, this sub-segment of the market will also present investors with idiosyncratic and event-driven opportunities to reduce portfolio “beta”—in terms of the overall sensitivity to global macro factors—and capitalize on a basket of less-correlated, fundamentally driven credit inflection points. In a scenario of looser global financial conditions, we anticipate that frontier markets will stand out as key beneficiaries of this shift. Countries such as Nigeria, Ukraine, Argentina and the Dominican Republic are particularly attractive to us in this context.
Exhibit 3: Comparing Spreads
Source: Bloomberg, Western Asset. As of September 30, 2023. The J.P. Morgan Emerging Markets Bond Index Global Diversified (EMBI Global Diversified)-Investment Grade (IG) tracks total returns for the IG component of US dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady bonds, loans, Eurobonds. The index limits the exposure of some of the larger countries. The J.P. Morgan Next Generation Markets index (NEXGEM) measures the US dollar-denominated external sovereigns debt from frontier markets. The Average Option Adjusted Spread (OAS) component of the Bloomberg US Corporate High Yield Index measures the average OAS of the USD-denominated, high-yield, fixed-rate corporate bond market. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
Definitions:
"AAA" and "AA" (high credit quality) and "A" and "BBB" (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ("BB," "B," "CCC," etc.) are considered low credit quality, and are commonly referred to as "junk bonds."
High yield, or below-investment grade bonds are those with a credit quality rating of BB or below.
One basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).
A credit spread is the difference in yield between two different types of fixed income securities with similar maturities.
An Option-Adjusted Spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options.
The yield curve shows the relationship between yields and maturity dates for a similar class of bonds.
WHAT ARE THE RISKS?
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.