After a challenging 2018 in which emerging market debt (EMD) logged negative total returns, 2019 has begun with an eye-catching recovery. In the case of EMD sovereigns, all the losses of 2018 were erased by January 2019, and most EMD asset classes have added to or held onto their gains since then. So what’s next? While the journey for EMD historically has never been smooth on a month-to-month basis, we believe that the positive start to 2019 can be sustained.
First and foremost, the biggest driver of improved investor sentiment has been an unexpected change in U.S. monetary policy. Following four interest rate increases in 2018, U.S. monetary policy normalization generally was expected to continue well into 2019. However, in early 2019, the U.S. Federal Reserve (Fed) abruptly shifted to a much more dovish stance. This promptly led to the market pricing out any further U.S. rate hikes for the full 2019 calendar year. Therefore, we think that this implies a much more benign global liquidity outlook, with reduced upward pressure on U.S. bond yields and the U.S. dollar. In turn, this reduces pressure on emerging markets (EMs) to raise domestic interest rates. On the contrary, amid low inflation, we feel that some EMs could soon be in a position to cut domestic interest rates.
Even if a headline-making deal is not announced, we think the likelihood of major escalation in the “trade war” appears to be quite low.
Secondly, the other big headwind for EMs, particularly in the second half of 2018, was the backdrop of increasing U.S./China trade tensions. This situation also has improved, with the two sides agreeing to a “truce” in December 2018, and subsequently engaging in ongoing talks aimed at a more sustainable trade agreement. Even if a headline-making deal is not announced, we think the likelihood of major escalation in the “trade war” appears to be quite low. This is because for this to happen, the U.S. would have to extend tariffs to China’s information and communication technology (ICT) exports. However, this would be much more damaging for the U.S.’s own tech sector, including companies such as Apple, whose CEO has warned of an impact akin to “a tax on U.S. consumers.”
Finally, as illustrated in the chart below, the economic growth differential between EMs and developed markets (DMs) has largely been on a declining path in the era following the global financial crisis of 2007-2008. Specifically, this reflected slowing growth in most of the larger EM economies such as China, Brazil and Russia, coupled with a relatively resilient U.S. economy on the other hand. However, if consensus expectations are to be believed (due more to slowing U.S. growth rather than faster EM growth) the EM growth premium is now reoccurring. Other things being equal, we think that this should imply a greater propensity of investment capital to flow out of DMs and into EMs. Furthermore, as depicted in the chart below, our research shows that in the past, periods of rising growth differentials favoring EMs has tended to be supportive for EM currencies.
EM currencies generally track the growth differential between EM and DM
Source: International Monetary Fund, Bloomberg, as of December 2018. For illustrative purposes only. Past performance is no guarantee of future results.
* A FX (foreign exchange) spot comprises an agreement between two parties to buy one currency against selling another currency at an agreed-upon price for settlement on the spot date. The exchange rate at which the transaction is conducted is the spot exchange rate.
Even after the recent strong rebound, we remain relatively optimistic about the outlook for EMD for the remainder of 2019. This reflects big improvements in terms of two of the most important headwinds of the previous year, namely the global monetary/liquidity backdrop and U.S./China trade relations. Furthermore, we believe that the case for EMD is strengthened by an improving growth differential, which could bolster both EM capital inflows and currencies. Coupled with some of the other more longstanding attractions of EMD, including potential diversification* benefits and traditionally lower default rates, we feel that there is still ample scope for the positive start to 2019 to be sustained.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, as well as political and economic risks. These risks are enhanced in emerging-markets countries.