EM debt has kept its head

Nandini Ramakrishnan

Three weeks on from Brexit, the political and market fallout continues unabated. But there is one asset class that has posted solid returns for the year to date – and it has largely done it under the radar. Emerging market (EM) debt has quietly produced stellar performance in every sub-segment of the market – right across sovereign and corporate credit, rates and currencies – with returns up to the low double digits.

So how has EM debt kept its head in the post-Brexit maelstrom, when others around it are losing theirs? First, it has been supported by three globally important factors and events: central bank dovishness, a commodity market rebound, and China stimulus. Second, country-specific developments have also had a significant impact: market-friendly political change in Argentina, presidential impeachment and hopes for real economic reform in Brazil, and a sharp reduction in Russian geopolitical noise. The local currency EM debt total return index returned a whopping 23.8 per cent in sterling terms and 12.3 per cent in ‘local’ currency terms.

Despite this strong performance year to date, the outlook for EM debt remains constructive. Fundamental, valuation and technical factors – the foundations of our investment framework – are aligning in favour of the asset class. This does not mean that the path ahead will be smooth. Headwinds on the horizon still have the potential to unleash periods of volatility and underperformance. Among these headwinds, global growth risks, political pressure points and China’s ongoing growth deceleration and economic rebalancing all come with the power to disrupt proceedings for EM debt. However, with the underlying dynamics of the asset class pointing to positive trends, these challenges may provide opportunities to buy on dips in order to add exposure.

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Following a dip in the first quarter, growth across emerging markets has started to stabilise and gradually recover. This recovery has been driven principally by positive growth momentum in Latin America and Europe, albeit from a low base. The growth outlook for emerging markets should remain favourable in the coming quarters, supported by improved commodity price dynamics and encouraging political trends in Latin America in particular. Indeed, leading indicators (such as forward earning expectations) suggest as much, highlighting positive trends across EM regions.

Looking ahead, with a better outlook for commodities and EM currencies, and a modestly improved EM growth environment, there are tentative signs that the worst may be over in terms of corporate fundamentals. While it is sensible to remain cautious on the sector and there is a need for further data signals to confirm that corporate fundamentals are on the rebound, stabilisation is expected to occur in the coming quarters, or at least for the pace of deterioration to slow down.

At a sector level, EM debt prices are largely on the fair to cheap side relative to both fundamentals and history. Relative to global fixed income markets, EM debt valuations look increasingly compelling. Compared to both US Treasuries and inflation, EM local rates offer value and, against global government bonds, EM local yields are trading at the wider end of historic ranges.

Corporate and sovereign spreads have both seen considerable compression year to date, but are trading cheap relative to their respective five-year histories. With respect to the corporate sector specifically, the regional dispersion is noteworthy. Latin America and Europe, the Middle East and Africa continue to offer considerable value, while Asian spreads are trading tight to US investment grade. This is due in part to Asian investors rotating out of Japanese and core government debt and into positive-yielding Asian investment-grade credit.