In 2016, emerging market debt staged a spectacular recovery following the dreadful performance of 2015. It’s important to make a distinction, however, between local currency and hard currency. In 2015, local currency sovereign debt disappointingly fell 14.9%, while hard currency sovereign debt generated a small gain of 1.2%.
The key drivers were the ‘managed’ economic growth slowdown in China and the strengthening of the US Dollar versus most currencies. Negative sentiment, especially towards local currency debt, continued into the first couple of months of 2016, evidenced by the outflow spillover from 2015.
Although January 2016 was a challenging month for the asset class, performance through the rest of the year was stong. Local currency sovereign debt almost fully recovered the losses from the previous year. The tailwind to the solid performance was a stronger fundamental situation in many emerging economies, with expectations of higher growth than in developed markets. Additionally, after seeing the USD rally against almost every emerging market currency during most of 2015, valuations in local debt had become significantly more attractive.
For instance, the Mexican Peso depreciated by approximately 15% from January to December 2015. Although the Peso has continued on a downtrend, other currencies strengthened against the USD during 2016. In that vein, at least 5 percentage points of the index’s return through October were contributed by currency appreciation against the US dollar in most emerging markets.
On the hard currency side, the sovereign credit spread over US fluctuated during 2015, but ended the year back where it started. Still, valuations were attractive on a relative basis compared to those in developed markets. With spreads over US Treasuries tightening by at least 80 basis points between January and October 2016, the EM hard currency sovereign debt market generated a return of 13.3% over that period.
During the month of April, the hard currency sovereign market welcomed new issuance from Argentina. The country returned to capital markets after being shunned for defaulting on more than $80 billion in government debt in 2001. Following the election of a new government and the settlement of its 14-year long battle with debtholders, the country issued approximately $16Bn in USD-denominated debt. Managers with ability to invest in emerging markets welcomed the issuance given the relatively attractive yields on offer.
Brexit has No Impact...
For the most part, the 2016 rally in the asset class was smooth. Although within the period discussed, May was a challenging month, especially for local currency debt. The May ‘hiccup’ saw that part of the market lose 5.4% as investors digested the possibility of a Fed rate hike in the summer. In line with this, fund flows reversed but only temporarily. In fact, May was the only month of net outflows from March to October 2016 according to Morningstar data. The cautious stance and negative sentiment towards the asset class was short-lived and followed by a solid 5.9% return in June.
The UK’s EU referendum vote was almost a non-event for the asset class, especially for hard currency sovereign debt; it lost only 8 basis points on the days following the vote and returned 2% over the subsequent week. The perception that Brexit would be an event with global implications and ensuing defensive positioning by investors saw local currency sovereign debt initially lose 2% following the vote. However, upon realisation any Brexit-specific implications would be more relevant to Europe and therefore contained from the rest of the world, local debt fully recovered the losses over the following week by returning 3.1%.
...but Trump Hits Bonds
As the US election took centre stage in November, the up-until-then uninterrupted rebound took a dent. Donald Trump’s victory as the next president of the US sent ripples through emerging markets following the result. Local currency sovereign debt fell by 7.0% and hard currency sovereign debt lost 4.1% in November alone. Within the local currency space, the big loser has been the Mexican peso.
The currency continued on a downtrend against the US dollar and had depreciated by 16.8% from the beginning of the year to Nov. 20th. The speculation about Trump’s promises and stance on foreign policy has sent the currency into a nose dive. The market’s expectation is that Trump’s fiscal policies will send US government bond yields higher, which could be damaging to emerging economies as issuing debt in US dollars becomes more expensive. This could therefore challenge the relative attractiveness of the asset class and investors’ notions of its long-term value. Having said that, there isn’t a great deal of clarity yet on the US president-elect’s policies. And, if anything, the November sell-off may have created opportunities for investors to stop, reassess and consider whether they can stomach the likely rocky path ahead and adjust their exposure to the asset class accordingly.
A version of this article appeared in International Adviser magazine
