Emerging Market sovereign and corporate bond yields have risen steadily over the course of the year, with yields lifting visibly since the late summer. With sovereign yields now sitting at 7%, we have arrived at levels not seen since 2009. Is this an opportunity?
To begin, we first have to understand what is “in the price” and then decide how we think that may evolve from here (“what’s next?”). Investors’ apparent lack of confidence in emerging markets reflects in the asset class discounting a more negative world view versus that seen elsewhere. An analysis of emerging markets across sovereign and credit suggests that investors are looking for between 65 and 75 basis points of rate increases – a view that is more pessimistic than both our house view and that of the GS US Financial Conditions Index. Investors also appear pretty bearish towards China – and some of those countries that supply it. That feels excessively negative to us.
In China’s case, investors may be misunderstanding the depth and resilience of the second largest economy. Chinese policymakers had spent the last couple of quarters guiding the world’s second largest economy towards a soft landing, before Washington moved to curtail Chinese access to the US economy through tariff barriers and a revised NAFTA agreement. The move worried investors, who began to reduce growth expectations and holdings in response. In recent years, the main drivers of Chinese growth have been investment and consumption, which leaves Chinese policymakers well positioned (and equipped) to respond to the slowdown. Worth noting is the scale of the numbers involved: while US trade with China is around $680 billion annually, Chinese GDP prints in the region of $12 trillion. Meanwhile, it is notable that weakness in the Chinese currency has not resulted in substantial outflows from the country, even as CNY tested the 7.00 level against the dollar. We have revised our expectations downward in line with events. Should Chinese growth surprise even slightly to the upside of reduced expectations, the effect on emerging markets bond prices would be positive.
Meanwhile, Emerging market corporates have been adjusting their balance sheets for the reality of rising rates for some time. We’ve seen an active yield to call theme in the EM corporate space, which reflects issuers seeking to recycle and push out maturities. Emerging market corporates continue to offer investors access to 30% gross margins, 6 years of interest cover, and less operating leverage than US peers. A crucial distinction between emerging market and developed market credit informs this trend: far fewer emerging market corporate issuers are public companies, with family groups retaining control of many issuers. While public companies can make better creditors, family groups’ interests can align with investors due to reputational and cost of capital issues.
Another source of support for emerging markets might come from an unexpected direction. Two years ago, we saw substantial inflows into short duration credit strategies that offered investors a tool for reducing overall portfolio duration – without impacting income or elevating expense ratios. These strategies addressed a critical need for global portfolio managers, making the emerging market element of their composition essential incidental. In 2019, investors might seek protection from both a weakening dollar and rising interest rates, and in the process seek a high yielding, liquid, and investment grade asset class with negative dollar sensitivity. Such a thing does exist: It’s called emerging market local currency, and the space is beginning to see inflows.
We do not believe that emerging markets stand at a crossroads. While the lower mature market yields which resulted from QE may have made emerging markets’ higher income potential more attractive at the margin, they were not exclusively responsible for the development of the asset class over the last decade. However, we do think that the character of the opportunity has shifted from being beta driven towards a more alpha focused paradigm, a shift in market character which may advantage more flexible investment strategies.
Since 1994, emerging markets have rewarded investors that have bought into the asset class’ periodic weakness. The market may be entering a period where it offers attractive value. More positive Chinese growth numbers, or even evidence of the Fed stepping back from a pace of interest rate rises might be sufficient to deliver a rally in emerging markets bond returns. While emerging markets have at times presented more volatile performances than peer asset classes, the reality is that the space has delivered a competitive returns trajectory over the long term – and as a result, drawdowns have sometimes offered appealing entry points.