2020 presents investors with the challenge of accessing the return and diversification benefits of EM while minimizing drawdowns and volatility.
Emerging market ‘hard currency’ corporate and sovereign debt posted robust returns in 2019, despite poor global growth and a firm US dollar.
Valuations at the start of the year were attractive and Fed rate cuts and falling Treasury yields provided a powerful tailwind for USD-denominate emerging market debt.
Credit spreads have tightened this year but remain elevated compared to similarly rated debt in developed markets. But the boost from lower US rates and Treasury yields is unlikely to be repeated.
A US-China trade deal and inventory-led modest global recovery would be unequivocally positive for emerging market economies and assets, especially equity and currencies that global investors are currently underweight.
An acceleration in growth in the rest of the world relative to the US is typically associated with a weaker US dollar, while emerging market currencies, in aggregate, are cheap to fairly valued by historic standards.
With low inflation and relatively high real interest rates in several emerging markets, local currency debt offers attractive return opportunities, in our view.
Emerging market currencies undervalued by historical standards
Source: BIS (The Bank for International Settlements), Intercontinental Exchange (ICE) 10/2019, 10/2019
Idiosyncratic political and sovereign credit risk was the defining feature of emerging markets in 2019.
Populism and political risk were defining features of many emerging markets in 2019, especially in Latin America with protests in Chile and Ecuador, a political crisis in Bolivia and the return of the populist Peronist administration in Argentina.
Ukraine and Turkey were also been buffeted by geo-political tensions.
Venezuela remains in sovereign default and could be joined by Ecuador, Argentina and Lebanon.
The opportunity set for credit pickers seeking meaningful capital appreciation from distressed sovereign, as well as corporate, credit is wide and deep and is a potential source of return that is only weakly correlated to US rates and the dollar.
Volatility in sovereign risk has obscured the improved credit fundamentals of the corporate sector and contributed to the widening valuation gap between emerging and developed market corporate credit.
Our bottom-up projections suggest only a small increase in the annual default rate to around 3%, compared to 2.5% in 2019.
Lower corporate leverage in emerging markets
Source: JPMorgan; latest quarterly data for Q2 2019
The global macroeconomic backdrop is conducive to local currency emerging markets performing positively. We also see pockets of value in the EM high-yield corporate market and the opportunity set in distressed sovereign as well as corporate credit.
The challenge for investors is accessing the return and diversification benefits from EM assets in a manner that limits periodic drawdowns and volatility associated with the asset class.
Investors are increasingly attracted to strategies that can exploit opportunities across sovereign and corporate credit, hard and local currency debt.