The consensus at the beginning of 2018 was that EMD would do well, in spite of rising global rates. To quote J.P.Morgan Research, “EM fundamentals to support returns in 2018 despite rising DM rates”. Well, reality turned out to be quite different.
EM local currency posted the biggest losses, followed by EM sovereign and – albeit with some distance – EM corporate. Not surprisingly, investors are likely to feel disappointed, especially in view of the expectations a year ago. However, in defense of our colleagues in J.P.Morgan Research, the above statement contains more truth than the headline numbers may suggest. The main driver of negative returns in EMD was the US dollar and a handful of idiosyncratic stories, namely Argentina, China HY and Turkey. The evidence that fundamentals did support EMD is in our view the performance of the high grade (HG) rated segment: EM sovereign HG performed in line with US HG and EM corporate HG, even in line with the S&P 500. Even EM corporate HY performed moderately better than US HG, lending support to the view that idiosyncratic stories tilted the picture to the downside.
Undoubtedly, 2018 has put a dent in the return picture but has the longer-term story been affected? The chart above suggests that the impact has been relatively limited. Three-year returns for EM sovereign and corporate high yield are a bit lower than US HY, but over five years, EMD returns compare very favourably to other fixed income asset classes.
This is all the more remarkable as EMD has suffered a significant correction by historical standards, especially in terms of spread widening. In fact, it is the fourth biggest spread correction since 1998, and the two “maxi-corrections” involved extreme events (Russia default and LTCM in 1998, Global Financial Crisis in 2008).
The carry is your friend
EM sovereign and corporate yields have widened to attractive levels, even if the cost of hedging vs euro is taken into account. In view of this, we would expect institutional demand for yield-targeting or liability matching solutions to increase, as EMD not only offers an attractive yield-duration combination but also portfolio diversification.
Additionally, spreads are giving increasingly “buy” signals. Historically, the JPM EMBI Global Diversified has generated positive returns in one year when its spread was trading above 400 basis points (bp). Whilst dispersion of returns has been relatively wide at this spread level, returns have been positive since 2002. As spreads move wider, the dispersion and the risk of negative returns is likely to decrease. In view of this, we would regard a spread level of 450bp or higher as a strong buy signal for the EM sovereign bonds.
A final word on EM local currency, which has posted the biggest drawdown in EMD in 2018. As the first chart above illustrates, most of this was due to currency losses, or in other words, the strong US dollar. As a result of the sharp correction, EM local currency bonds, and especially EM FX vs USD, has now reverted to 2015 lows. Measured against the euro, it is even at historic lows. This combined with a yield of 6.64% looks very appealing. For local currency bonds, the critical question is therefore when will the USD turn from a headwind to neutral or perhaps even a tailwind. A main driver behind last year’s dollar strength was global growth de-synchronisation, especially between the US and the Eurozone. Therefore, any sign of re-synchronisation should be supportive for EM local currency. On a more structural point, the chart below also shows that Quantitative Easing (QE) likely played a major role in EM FX performance since 2013. It seems therefore plausible to assume that EM FX could return to pre-2013 return pattern as G3 central banks embark on Quantitative Tightening (QT).
In sum, 2018 has been a painful year for EMD. However, it has been a painful year for many asset classes, including equities, and some parts of EMD performed well compared to peers, in particular EM sovereign and corporate high grade. The correction has been significant and as a result the opportunity cost of selling EMD at these levels has become very high. The carry potentially to be earned is attractive, EM FX is at long-term lows, and buy signals from EMBIG spreads are increasing. Risks (trade war, global financial conditions, idiosyncratic EM risks) are well flagged and priced, but are still expected to fuel volatility. Nevertheless, EMD could offer attractive opportunities in 2019.
 J.P.Morgan, Emerging Markets Outlook and Strategy for 2018, November 21, 2017