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Emerging market fixed income: an attractive entry level after the correction

27 July 2018 - Jean-Charles Sambor, Deputy Head of Emerging Markets Fixed Income

Emerging market debt has been the subject of much interest over the last few years, but recent volatility has created uncertainty about the asset class. We are convinced that besides offering an attractive return/risk ratio and the potential for high returns, current valuations constitute an attractive entry point.

Emerging market debt: considerable potential for growth

Emerging debt is no longer an asset class that simply provides diversification. Nor is it a niche asset class. Most institutional investors now view it as a core portfolio allocation, for both hard currency and local currency debt. Each component within emerging debt is now a broader asset class than US high-yield debt. Total outstanding issuance of emerging debt currently stands at more than USD 18 trillion. As the Chinese market opens up to non-resident investors, the potential for further growth seems considerable.

 

The recent correction is giving rise to opportunities

Emerging market debt is a more volatile market than the pure investment-grade debt market with annualised volatility of 7% to 10% over the past 15 years (depending on the type of emerging bonds), but with annualised returns of 7% to 8% in US dollar terms over the same period.

The period since this February has certainly been volatile. To put matters into perspective, in the wake of the election of President Trump, emerging debt temporarily became the pariah among asset classes, before rallying strongly in 2017 when geopolitical fears subsided. This rally ended rather abruptly in February 2018. In our view, this recent correction is healthy – valuations for emerging debt in hard currency and more selectively in local currency are once again attractive. Volatility will likely remain high in coming months, but this should lead to new opportunities.

 

No systemic crisis, but greater dispersion in engines of performance

Economic growth is somewhat weaker than forecast in emerging countries, but macroeconomic imbalances are concentrated in a limited number of countries (Turkey and Argentina). In our view, there is no systemic crisis, but a greater dispersion in the drivers of performance for the asset class. In the short term, there is uncertainty about emerging market currency valuations, but longer term, we believe these currencies are undervalued relative to the US dollar.

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The six key themes for US Treasuries in Q4 2018

The primary themes impacting the yields of US Treasuries and the pricing of future levels of inflation (via breakeven inflation rates (BEIs)) have changed little in the last few months. They continue to generate a range-trading environment for US Treasury bonds and TIPS.