Emerging markets offer attractive alternatives to fixed income investors searching for yield amid the trillions of dollars of negative-, zero-, and low-yielding debt globally. However, this asset class is far from homogenous, making it difficult to generalize on opportunities versus risks. On the positive side, the investible universe is broad and diverse, offering potential opportunities—if investors know how and where to look. A flexible approach to emerging markets, utilizing the three major asset classes—hard currency corporates, hard currency sovereigns, and local currency sovereigns—allows us to take full advantage of opportunities presented by macroeconomic cycles while also responding actively to risks.
Investment Grade Hard Currency
The big risk within investment grade hard currency markets is interest rate risk, and we saw this during the first quarter of this year. We do not want to take on duration risk at this point given the associated price risk with developed market sovereign duration. While our U.S. bond models are no longer showing extreme overvaluation, some risks to U.S. Treasuries remain. Near-term, we could see a Treasury rally as they are attractive when currency hedged for foreign-based investors, relative to European and Japanese government bonds. However, looking a little farther out, the U.S. growth outlook looks quite strong, indicating we could see some upward pressure in Treasuries.
Across developed and developing countries, many markets are trading at historical low yields and spreads—or at least close to pre-COVID levels. The strong U.S. growth outlook could be a powerful catalyst that could put upward pressure on developed market rates, fueled by the reopening of the global economy, the acceleration in vaccination rates, further fiscal stimulus packages, and the regime shift from the Federal Reserve (Fed) to average inflation targeting, which would keep monetary policy stimulative for longer than normal. We expect the potential for continued repricing of developed market rates to put pressure on some segments of emerging markets as well, including longer-duration investment-grade corporate bonds and investment-grade sovereign credit, given tight spreads and increased interest rate sensitivity.
Within emerging market hard currency investment grade bonds, we think it is prudent to be shorter duration or at least hedge the Treasury risk component, given the low yield per unit of duration today (see Chart 1). We see some reasonable yield opportunities in 5- to 7-year investment grade bonds. As long as the Fed can re-anchor market expectations regarding its regime shift and commitment to average inflation targeting, this clarity could lead to stability in the 5-year U.S. Treasury. At this point, we consider investment grade hard currency as a place to reallocate if we become more cautious on the growth outlook, as some investment grade segments should perform relatively better under these circumstances.
High Yield Hard Currency
While investment grade bonds face risks from rising rates, high yield bonds generally may be poised to benefit from what could be an outsized global economic boom. Emerging markets could see a tremendous recovery in growth as economies reopen. The International Monetary Fund (IMF) is forecasting 6.7% and 5% growth in emerging markets in 2021 and 2022, respectively. Given the prospects for recovery, high yield emerging markets may offer some attractive opportunities, including several hard currency high yield sovereign bonds, but investors must be extremely selective given the elevated risks of default within this universe. To help mitigate some of the risks faced by these countries because of the pandemic, the IMF announced a potential $650 billion special drawing rights (SDR) allocation for its member countries. These reserves could provide much needed liquidity to help some emerging sovereign markets bridge the gap until a more robust reopening. However, further delays in vaccination rollouts could postpone recovery and put further strain on fiscal accounts in some of these countries.
Valuations remain broadly tight across CEMBI high yield, offering little value on yields or spreads (see Chart 2). However, there is the appearance of some cheapness in EMBI high yield. For example, we see some valuation opportunities in EMBI high yield countries exposed to tourism and a recovery in oil. Selectivity is necessary due to a higher number of default risk candidates. Valuations for the JP Morgan EMBI high yield universe remain wide compared to EMBI investment grade, with high yield spreads trading at 4x the spread of the investment grade segment (see Chart 3). While this multiple is still near the all-time high, spreads in EMBI HY have come in from the distressed highs of 2020. Certainly, some of these countries face challenged debt dynamics, but several could see recoveries, particularly if the IMF’s potential increased SDR allocation delivers needed short-term liquidity support as the economy reopens. However, on the whole, high yield, hard-currency sovereigns are bifurcated, flanked by bonds rated high yield but trading at low yields and those flirting with default with little in between. This unique dichotomy warrants caution for investors combing this space for opportunities.We also see some limited opportunities in corporate bonds in both cyclical and non-cyclical sectors of the global economy. There are idiosyncratic prospects in basic industries, shorter-duration opportunities in sectors with exposure to economic reopening, and some higher coupon yield-to-call opportunities that may provide incremental returns with reduced volatility. Chinese corporate bonds still trade at spreads a bit wide relative to history. However, it will be important to monitor how policymakers address leverage, particularly in the property sector. While we anticipate that the People’s Bank of China will strive to avoid a policy cliff, aggressive deleveraging could potentially trigger more bond defaults and a broader sell-off. There also are some attractive opportunities in the quasi-sovereign space in Latin America.
Local sovereign market yields backed up during the first quarter, following the yield on the JPMorgan GBI-EM index touching all-time lows in the fourth quarter of 2020. With the stability in the U.S. Treasury market currently, particularly in real rates, we see some attractive opportunities in longer-duration local currency sovereign bonds in several markets. Our forward real yield valuation index rose during the first quarter (see Chart 4), and we now see some attractive opportunities in a handful of markets. We recently added duration back in a few markets in Latin America, Asia, and Europe.
However, the biggest valuation anomaly we see is within emerging market currencies, specifically the commodities-oriented currencies, many of which have underperformed terms-of-trade following the rally in commodities. These currencies also have largely underperformed manufacturing-exposed currency markets (see Chart 5). Some of this underperformance could be due to historically low policy rates, including negative real central bank rates in several markets, as well as near-term political and election uncertainty and spotty COVID-19 vaccine rollouts. However, these currencies could rebound as some central banks are starting to gradually hike rates while others are likely done cutting. Rising front-end yields against a backdrop of better economic growth could be supportive of emerging market currencies.
Monitoring the Outlook
With respect to the outlook for emerging markets, there are several risks to monitor closely. The first is changes in China’s credit impulse. China’s credit impulse is expected to decline later this year, with some officials pointing to the need for banks to rein in credit lending. While these circumstances would typically create challenges for other developing countries, it is unclear how aggressive China’s credit growth reduction will be relative to past cycles, and what the subsequent impact on emerging markets might be. The second factor to watch is Fed policy. The new regime shift to average inflation targeting would imply that the Fed will remain on hold for an extended period. However, markets are pricing in more hikes than what the Fed is telling us. In this case of markets versus the Fed, who is right? U.S. real rates have been stable for two months, but rising real rates pressured local rates earlier this year. Since they also will impact emerging markets going forward, we will be keeping a close eye on U.S. real rates.
Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.