A strong start to the year begs the question: can it continue?
At the end of December, we discussed the value opportunities that have been created in the asset class after a significant price decline in 2018, subsequently sharing our views in our last blog post of the year.
Fast forward a few weeks later, and our optimism has apparently been rewarded: EM sovereign is up by 3.5% year-to-date as of 28-Jan-2019, and EM corporate is up by 2.2%.
While such recoveries are not unusual in emerging markets (Exhibit 2), the key question becomes “can this recovery continue?”
Carry is our good friend, but the path is never smooth
In fixed income, carry normally gives us a good start when forecasting returns. However in EMD, it is not always the case on a year to year basis (Exhibit 3), despite the fact that in the longer horizon total return tends to either be in line with or exceed the carry. What could potentially prevent us from earning the carry in 2019, or, in a more extreme scenario, what needs to happen for the asset class to post negative returns despite its carry?
Looking at EM hard currency sovereigns: the breakeven spread and US treasury yield have moved a lot higher. Taking the market levels at the end of 2018, for the sector to lose money over a 12 month investment horizon, US treasury yields need to go up by more than 50bps, while spread levels would need to widen further to more than 450bps – and these two movements need to happen concurrently during a 12 months horizon (Exhibit 4). This appears to be quite an extreme scenario in our view. Both spreads and US treasury yields are normally negatively correlated, and for the past 15 years, the EM sovereign spread has only shot beyond 450bps once, in 2008.
A few main risk factors that had hurt the asset class last year may wane in 2019 (Exhibit 5). Quantitative tightening and China/Trade war evolvements will keep volatility high, but re-synchronizing global growth, a dovish Fed and a more “normal” EM political agenda allow EM to rebound. There are also reasons for optimism when it comes to the technicals: after consistent outflows last year, we know that a lot of crossover and other investors now hold significantly reduced allocations to the asset class. Supply and demand picture is also looking more favourable this year given the lower net supply forecast.
Our base case scenario is a soft landing for the global economy in 2019. This should offer a more favourable macro environment for EMD than the one that existed through most of 2018. In addition, EM spreads and currencies have adjusted quite a long way in 2018, giving 2019 a good yield cushion to start with. With that being said, conditions are set for improved performance for the asset class in 2019.