This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here Esty Dwek, Investment Strategist at HSBC Private Bank, asks 'When will emerging market debt bounce?'
Emerging market assets have not recovered as quickly as developed market assets since the May correction. In our view, emerging market debt still has some hurdles to clear before we see better performance from the asset class. We believe that if Treasury yields stabilise around current levels, EM hard currency debt spreads can gradually compress, although it may take time to materialise.
Following the sharp correction we saw across the emerging markets (EM) in May, we believe it is only fair for investors to wonder whether, and when, EM assets will recover.
While most other asset classes have rebounded since then, EM assets remain relatively unloved. In this piece, we focus on emerging market debt as it has not recovered to the extent that other fixed income segments have, such as developed market investment grade and high yield credit.
Indeed, broad developed market credit has performed well recently, with high yield and investment grade spreads tightening significantly in the past month – in some cases back to early-May lows. At the same time, EM credit spreads have recovered only about half of the May spread widening.
Still hurdles ahead
In our view, a number of factors are capping EM debt performance in the short term, a trend which may persist for some time yet.
First, growth concerns across many of the emerging markets, and most notably in China, are, in our view, one of the main reasons why EM debt has failed to recover. The Chinese slowdown has captured headlines and PMIs across the region have pointed to a deceleration in growth, with little reversal in sight. In contrast, the US recovery continues to develop, and even the Eurozone and the UK are showing signs of improvement. In our view, until we see a clear stabilisation in EM growth, especially in China, sentiment towards the region’s assets, including fixed income, is likely to remain subdued.
We are seeing a number of investors question the medium-term emerging market fundamental story, although we do not agree with this view. We believe that the long-term growth outlook for EM remains strong, supported by rising domestic consumption and healthy fundamentals. Nonetheless, we acknowledge that, for now, the love affair may be broken and it may take some time to rebuild investor confidence.
Indeed, we have not yet seen a reversal in the outflows from the emerging markets. Following USD18 billion of outflows in June, July saw USD5 billion of outflows –encouraging, but still in the wrong direction. Investors do not seem ready to dive back into the emerging markets, there is some lingering fear that the worst may not be over yet.
Furthermore, investors who had built up significant long positions in EM in recent years, supported by abundant global liquidity and robust growth, are reducing these overweights and keeping investments closer to benchmark. Of course, the prospects of reduced global liquidity in light of the Federal Reserve’s tapering plans is exacerbating the situation, as flows are less likely to follow old routes to EM when the developed markets are improving, and some may even question if the yield pick-up in the emerging markets is enough.
One final obstacle comes from the expectations for bond supply to increase notable until the end of the year. We had seen very little supply since the May correction, as companies have waiting for better conditions, but issuance cannot be held up much longer, which could weigh on price dynamics in the coming months.
Local fundamentals are still OK
While in the short term there are still hurdles to overcome, we highlight that the fundamental picture for EM debt remains solid, and should not be underestimated. Indeed, even though growth is slowing across much of the region, it is still higher than in the developed markets, and it is likely to pick up in the coming quarters. Moreover, EM countries generally have healthier credit positions, with lower private and public debt levels, and lower deficit levels, with a few exceptions. These are Brazil, India, Turkey and South Africa, where the current account deficit is notable, and these countries have suffered more than others recently. We are also seeing a credit ratings upgrade trend across EM, noting the improvements in the debt structures of many countries.
The pick-up in yield is also not negligible. While higher yields on safe haven developed market debt may reduce the differential between developed and emerging market assets over time, yields in EM remain attractive in our view, especially following the correction.
Upside potential – it may take time
If Treasuries stabilise around current levels – which central bankers seem to be aiming for – we see the potential for spread compression and positive performance in EM USD- denominated debt, although it could take some time to materialise. We believe that there is more potential for EM sovereign spread compression as corporate spreads proved more resilient and benefited from the recovery across global credit.
We believe that EM hard currency debt is likely to recover before local currency debt, as EM currencies are likely to remain volatile in an environment of USD strength, and some countries may be happy to see their currencies depreciate in order to improve deficit positions and competitiveness. We believe that more stable Treasury yields will gradually give investor confidence to step back into EM, and that hard currency debt will be the first stop. We remain cautious ahead of such a stabilisation, but gradually look for select opportunities in hard currency debt, as we remain optimistic about the performance potential from the yield pick-up and the spread compression we expect to see.
