- 2018 was a volatile year for Emerging Market fixed income, due to a combination of negative global and idiosyncratic factors. Still, the relative performance of the different EMFI sub-asset classes was in line with their longerterm risk-adjusted trends.
- The outlook for 2019 is more positive as EM and developed market growth should remain solid, EM political risk is easing, and commodities should rebound from their recent lows.
- Market technicals and valuations also appear supportive.
Emerging fixed income: Heterogeneous performances confirm long-term trends
EM have faced several headwinds so far this year, ranging from higher US rates, a stronger dollar and heightened trade tensions to weaker commodity prices and deteriorating fundamentals in a number of Emerging Market countries like Turkey and Argentina. As a result, EM debt markets have posted negative performances year to date.
Once again, however, the performances of the different EM debt sub-asset classes have been diverse. In particular, EM corporate bonds (-2.5% this year up to 30 November) have fared much better than EM sovereign bonds (-5.5%) or EM local bonds (-7.4%). As we have been asserting for a long time, this resilience can be explained by several factors: greater diversification, better credit quality, a more stable investor base, and, importantly, a shorter interest rate duration.
EM corporate investment grade (IG) bonds, in particular, lost only 1.8% over the period, outperforming EM sovereign IG bonds (-4.0%) and US IG credit (-3.7%), thanks to their shorter duration of only about 5 years compared with about 7 years for EM sovereign and US IG credit.
Local debt, in contrast, underperformed, due to the sharp depreciation of Emerging Market local currencies against the US dollar as well as the lack of diversification opportunities with only 19 countries, vs. over 150 issuers in the EM sovereign index and over 640 in the EM corporate index. EM local markets continue in effect to demonstrate poor risk-adjusted performance with higher volatility and drawdowns than hardcurrency debt. We therefore continue to believe that this subasset class is best suited to investors with a high risk appetite and the ability to trade tactically and selectively to seize investment opportunities when and where they arise, rather than to investors seeking a more long-term strategic allocation to Emerging Market.
Looking ahead, we believe that EM have likely resolved some of 2018’s economic difficulties, which should make 2019 a more fruitful year for Emerging Market fixed income investors. The worst of the policy uncertainties in Argentina and Brazil are behind us. The risks in Turkey appear more quantifiable. Overall EM GDP growth should still be well in excess of the average in developed markets. Also, EM market technicals have been cleaned up and are now more favourable than they were a year ago.
Global market vital signs: a strong heartbeat
Global activity should remain healthy in 2019, with GDP expected to grow by 3.1% over the year, according to the IMF (October 2018). This lies between 3.2% in 2018 and a post-GFC average of 3.0%. Despite their expected slowdown, developed markets are still doing well (2.1% from 2.3%), which should translate into solid demand for goods and services out of EM countries.
EM growth should also be strong in 2019, with the IMF anticipating 4.7%, a level similar to 2018. Latin America will be picking up momentum on the back of monetary loosening. Africa and the Middle East are also due to do better as the past commodity-related deleveraging pressures dissipate. These are important growth supports offsetting the likely slowdown in China. We expect this slowdown to remain moderate, adjusting to the government’s deleveraging policies as Beijing opts for healthier/slower growth over leveraged/rapid growth. Trade tensions with the US are complicating the outlook, with Chinese GDP growth on course for 6.2% in 2019, down from 6.6% in 2018. If the trade tension between the US and China increase, the Chinese authorities will probably respond with more fiscal loosening first (government debt levels of 60% of GDP, compared with the G7 average of 117%, are not yet a constraint) ahead of monetary easing.
Developed markets to extend monetary policy normalisation
We are expecting continued monetary policy normalisation in developed markets, and higher yields. European QE is ending and the US is entering the fourth year of rate hikes, with Fed Funds rates up from 0.25% to 2.50%. We expect two more rate hikes in 2019 as US growth remains solid (though decelerating to 2.5% in 2019 from 2.9% in 2018 according to the IMF), core PCE inflation is in line with the Fed’s target of 2.0% and risks to inflation are biased to the upside given wage pressures. Against this backdrop 10-year yields should end 2019 at around 3.50% (about 25 bp above their 2018 highs).
Rising US policy rates and yields will likely continue to restrain EM assets, and notably the currencies of countries where monetary policy is not being tightened (such as in North-East Asia with its low rates of inflation and downside pressure on growth in line with China). For EM credit returns, the impact of rising US Treasury bond (UST) yields will be partly cushioned by the wider spreads, as in the first 11 months of 2018, average Emerging Market sovereign and corporate spreads over UST increased by 110 bps and 76 bps respectively.
Less political risk ahead
2018 was marked by critical elections with uncertain outcomes in both Brazil and Mexico. These were a major source of asset market volatility. In Turkey, the outcome of the presidential election was more predictable: Recep Tayyip Erdogan, who has been leading the country, first as Prime Minister then as President, since 2003, won. But the unexpected cabinet changes and the acceleration of alreadyhigh inflation led to a currency collapse.
2019 promises a little less political excitement: Indonesia and India are heading into presidential/parliamentary elections in April while South Africa has parliamentary elections in May. Argentina’s presidential elections will come in the last quarter. South Africa’s elections are causing us the most unease because a slim win for the African National Congress (ANC), due to weak GDP growth, would undermine the legitimacy of its business-friendly leader Cyril Ramaphosa. In India, Prime Minister Modi’s approval rating is strong, at around 50%, and the Bharatiya Janata Party seems very likely to win a majority in parliament, which would mean continued business reforms. Indonesia’s president Joko Widodo enjoys an even higher approval rate (70%) and his party is also expected to win in 2019 with a strong mandate to continue pro-investment/conservative fiscal policies. Late 2019 elections in Argentina will decide whether the promarket president Macri is given another chance despite the currency collapse and sharp economic downturn of 2018. We are optimistic on this front as the IMF loan program is slowing the depreciation of the peso, which at some stage should bring down inflation expectations and allow interest rates to be cut again. This holds hope for the economy and might help Macri, or another ruling party candidate, creep ahead of the (fractured) opposition come polling time..
Senior Macro and FX Strategist
Emerging Market Fixed Income
Senior Investment Specialist
Emerging Market Fixed Income