Is Emerging Markets Debt Oversold?

June 27, 2018

Almost halfway through the year, emerging markets debt (“EMD”) returns are negative for the year, due to a variety of economic and political events. The most commonly cited explanations include the following:

• The ongoing Fed rate hikes, including the first two this year in March and June, and also those expected in September and December as well as two more next year;
• As discussed in our chart last week, the European Central Bank (“ECB”) will end its quantitative easing program in October;
• The ongoing protectionist sentiment among the U.S., China and other countries that may stifle global commerce and potentially, global growth;
• Italy’s two populist parties’ inability to initially form a coalition, which stoked fears of Italy’s exit from the EU — but they have since formed a coalition and selected a prime minister;
• A truckers’ strike in Brazil that paralyzed many of the country’s major roads;
• Turkish President Erdogan’s claim that higher interest rates cause inflation, and finally;
• A run on the Argentine peso that exacerbated further downward pressure on the currency, resulting in a $50 billion emergency IMF loan.

The chart above illustrates how spreads have risen, which has led to higher yields and thus losses for EMD strategies so far in 2018. More specifically, the chart shows the spreads for the hard currency sovereign and local currency sovereign indices versus their averages. The hard currency sovereign index tracks bonds issued by emerging markets countries denominated in U.S. dollars or euros. The local currency sovereign index tracks bonds issued by emerging markets countries denominated in the issuer’s local currency, such as the Brazilian real or Malaysian ringgit.

Looking ahead, it could be argued that tightening by both the Fed and the ECB may slow global growth, raise interest rates, and strengthen currencies in both the U.S. and Europe, none of which would be favorable for EMD returns. However, at this point these moves may already be priced into current yields, and the worst of their impact on returns has already been felt. If so, what’s left are “idiosyncratic” headlines, which should theoretically have less of an impact on future returns.

Ultimately, despite the EMD market’s sensitivity to headlines, EM fundamentals remain strong. Leverage among issuers remains low on an absolute basis and is lower than developed market issuers. GDP growth remains high and is higher than developed market issuers. Furthermore, current account balances and inflation rates are generally improving. These strong fundamentals may suggest an impending reversal in the second half of the year for EMD returns.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.