Why EM Debt Can Continue To Challenge The Doubters

EM debt’s diversity helps it overcome many common investor concerns.

KEY INSIGHTS
• Emerging markets (EM) debt can perform in different market environments. Its diversity and growth mean that many concerns are no longer valid.
• Emerging markets offer many defensive opportunities that have performed similar to developed market sectors during periods of volatility.

Positive reforms and fundamentals mean that many areas of EM show favorable growth outlooks with less risk of policy error sell‑offs. Emerging markets (EMs) delivered strong returns in the first half of 2019, and we are confident that EM still offers many long-term investment opportunities. However, with geopolitical and economic concerns in the headlines, many investors continue to question the longer‑term outlook for the asset class based on a misconception that it is a high‑risk and high‑beta investment. We address some of the common investor questions and explain why the concerns either are no longer true or only tell part of the story.

EM Debt Reality Reduces the Risks | EM diversity helps overcome many common concerns

1. Is EM a high-risk investment during periods of macro volatility?
Contradicting the stereotype of a volatile, higher‑beta asset class, many regions and sectors of EM offer defensive opportunities that can outperform other asset classes during periods of risk aversion. The breadth of opportunities in EM is one of its key strengths.

This is not to suggest volatility is not a concern. Rather, it means investors need to do their homework and identify sectors and regions with lower‑beta track records when looking for defensive assets. Many areas of EM debt have behaved more defensively than some developed market (DM) counterparts. Investors concerned about global growth or trade disputes can actively seek out certain areas of EM rather than solely look at DM safe havens.

EM corporates stand out as a defensive sector due to their strong fundamentals. Asia credit, which has grown substantially in recent years, has performed more in line with DM investment‑grade, for example, than other higher‑volatility EM sectors.1 The defensive sectors of EM also offer opportunities to diversify portfolios away from DM regions with the most concerning growth outlooks and large debt accumulations. EM is also becoming less correlated to some of the higher‑risk sectors of DM. Traditionally, U.S. high yield and EM debt have displayed a degree of correlation due to an overlap of investors seeking higher yields than investment‑grade DM debt.2 However, this correlation has fallen in the past year and is below long‑term averages. We believe this trend demonstrates the increasing idiosyncratic behavior of EM debt. Therefore, investors may achieve more consistent performance by locating segments and specific names within EM that offer strong fundamentals, rather than focusing primarily on wider market tone.

EM debt offers one of the most attractive opportunities for investors to gain exposure to these still strong fundamentals. Compared with EM equity, hard‑currency sovereign bonds boast absolute returns double that of EM equities over the past 25 years.3

2. Is the risk of policy error significant?
While negative surprises in political or monetary policy can impact both EM and DM investing, an active approach can help avoid sudden sell‑offs. The positive reforms in many EM countries mean that most are no longer just one or two bad decisions away from a crisis. Bottom‑up, on‑the‑ground research can identify countries that are committed to consistent, market‑friendly policy directions and reducing investors’ exposure to policy error and help avoid those that are slipping in the wrong direction.

Even when significant sell‑offs do hit certain EM countries, we don’t believe this constitutes a systemic risk to the wider asset class. For example, Turkey and Argentina have dominated headlines in the past two years as markets quickly lost confidence in the political direction or the ability of policymakers in each country to manage their currencies and fiscal accounts. Some investors pulled out of EM as a whole at the height of these crises as they sought safety in more familiar core DM assets.

However, many of these contagion‑driven sell‑offs in 2018 and 2019 were short‑lived and actually created better long‑term opportunities. An active, disciplined approach can reveal lower‑beta corners of EM, such as selecting Chinese state‑owned enterprises that are likely to be less affected by sell‑offs elsewhere. Furthermore, sudden downturns can create opportunities to go against the grain and buy cheap assets. By uncovering when to re-enter a distressed credit or sector, investors can improve their potential for long‑term gains.

Figure 1: EM Economies Are Less Reliant on Trade With DM
EM exports to developed versus other emerging markets countries | As of June 30, 2019

Source: Goldman Sachs Investment Research/Haver Analytics

3. Can EM assets perform amid a mixed global economic outlook?
The growth of EM as an asset class in recent years means that investors can find a wealth of investment opportunities in different global economic environments. While we do recognize that strong growth is important for the prospects of EM, this must be kept in perspective as we see several reasons for optimism in different economic backdrops.

First of all, many EM countries enjoy favorable economic growth rates supportive of fundamentals. Investors need to cast aside any preconceptions of EM being a single investment opportunity and take the time to look at individual EM sectors and regions to find attractive investments.

Currently, we are confident that many areas of EM can perform even if China or major DM economies cannot resurrect their growth rates. Countries that have committed to positive fiscal and political reforms can continue to thrive. Many EM economies display a growing middle class that is underpinning domestic demand. Consequently, EM is no longer just an export‑driven investment reliant on DM, or even Chinese, economic growth. EM economies are trading with other EMs now more than they are with DMs.

Second, EM credit is on a strong footing. Corporate fundamentals remain favorable. Issuers have relatively low debt levels, and companies have been able to extend bond maturities and buffer balance sheets.

Growth concerns in key global markets could also become tailwinds as central banks appear to be shifting to more accommodative policies. While a slowdown in China will impact some EM economies, the potential for China to ramp up stimulus measures could provide a floor to growth levels. Similarly, the U.S. Federal Reserve’s policy is directed at prolonging the growth cycle with the potential for further rate cuts over the course of 2019. Meanwhile, the European Central Bank appears ready to introduce stimulus measures in the form of rate cuts or monthly bond purchases.

These central bank policies could suppress core DM yields, which would lend further support to EM assets. Therefore, investors should regard the global economic uncertainty as potentially opening up an opportunity rather than as just a downside.

4. Should investors wait for sustained inflows before committing to EM following periods of volatility?
History shows that EM has consistently rebounded and rebounded quickly following downturns. Some EM investors were still licking their wounds after the difficult 2018, and one could be forgiven for thinking that it could take some time before investors gain confidence again to fuel a sustained recovery. However, EM debt’s track record following periods of negative returns is for sharp upturns leading to sustained periods of positive returns.

Therefore, the strong start to 2019 should not have come as a surprise. It also should not be treated as an aberration. In our opinion, investors should not lose sight of EM’s ability to rebound following periods when macro volatility results in short-term weakness. Based on both history and the strong fundamentals, we believe EM offers ample opportunity for sustained strong performance.

Figure 2: Rebounds Have Typically Followed Negative Returns
EM debt rolling 12-month returns | As of June 30, 2019

Past performance is not a reliable indicator of future performance. | Shaded areas are periods of trailing 12-month negative returns. Chart refers to the J.P. Morgan EMBI Global Index and the J.P. Morgan Corporate Emerging Markets Bond Index Broad Diversified.

WHAT WE’RE WATCHING NEXT
Slower growth in the U.S. could cause the dollar to depreciate, improving potential opportunities in EM local bonds. The greenback has displayed relative strength in recent years against most EM currencies as its economy has outperformed, helped by the late‑2017 passing of the Tax Cuts and Jobs Act. However, the fiscal boost is expected to wane, and the market is expecting the world’s largest economy to continue to ease in the year ahead. Even if the U.S. growth remains solid, it may fall back into line with much of the rest of the world, which could help EM currencies show improved stability in the months ahead.


By T. Rowe Price
Ben Robins, Portfolio Specialist, Emerging Markets Debt Strategies

Endnotes
1Asia IG: JPM JACI Diversified, z spread; US IG: Bloomberg Barclays U.S. Aggregate Corporate Investment Grade Index, OAS; Euro IG: Bloomberg Barclays Euro‑Aggregate Index, OAS.
2Source: J.P. Morgan. Data analysis by T. Rowe Price. J.P. Morgan. Information has been obtained from sources believed to be reliable, but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright © 2019, J.P. Morgan Chase & Co. All rights reserved.
3As of December 31, 2018. Sources: J.P. Morgan and MSCI. Data analysis by T. Rowe Price. J.P. Morgan. MSCI. EM debt is based on the JP Morgan EMBI Global Index. EM equity is based on the MSCI Emerging Markets Index.
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