Notwithstanding the strong performance of emerging-markets debt so far this year, the outlook for the asset class is becoming increasingly constructive, suggesting continued outperformance. There are risks, to be sure, but we at J.P. Morgan Asset Management would seek to be buyers on market hiccups.
Recent returns for some sectors of emerging-markets debt have been stellar, in the low double digits. Globally important factors and events — G-3 central bank dovishness, a rebound in commodities and China stimulus — have had an important bearing on performance. So too have country-specific developments: market-friendly political change in Argentina, a new president and hopes for real economic reform in Brazil, a sharp reduction in Russian geopolitical noise and worsening political developments in both South Africa and Turkey.
There are a number of positive factors aligning in favor of the asset class, which is not to say that the path ahead will be smooth and uneventful. Headwinds remain on the horizon. But, if anything, these headwinds may provide opportunity to buy on the dips.
Here are some reasons for our constructive outlook:
Emerging markets have stronger fundamentals, having undergone a considerable external adjustment over the past few years. Following a dip in the first quarter, growth across emerging markets has started to stabilize. This recovery has been driven principally by positive growth momentum in Latin America and Europe, albeit from a low base, and is supported by improved commodity price dynamics.
The picture for developed markets is less encouraging, inhibited by sluggish growth conditions and still-elevated government debt levels. This divergent growth picture should result in a moderate widening of the growth pickup for emerging markets over developed markets, in excess of 2 percentage points. Historically, a wider-growth alpha has tended to support capital flows into emerging markets, benefiting asset prices and currencies in the process.
We’ve seen significant improvement in current accounts across emerging markets, with many now pushing toward surplus and fewer posting deficits in excess of 3 percent of GDP. Add to this the stabilization and improvement in commodity prices, and the terms of trade deterioration that has afflicted emerging-markets economies in Europe, the Middle East and Africa, as well as Latin America, should turn more positive this year. Taken together, these greatly improved external metrics should support a recovery in emerging-markets net capital flows.
Taking a bottom-up perspective in the corporate sector, we also strike a marginally more positive tone. Emerging-markets corporates have reacted proactively and prudently in the face of a deteriorating environment by slashing capital expenditures, reducing dividends and using the proceeds to purchase their own corporate debt.
Relative to global fixed-income markets, emerging-markets debt looks attractively priced. Compared with both Treasuries and inflation, emerging-markets local rates offer value; against global government bonds, emerging-markets local yields are trading at the wider end of historical ranges.
Emerging-markets debt offers considerable opportunity for yield pickup. In an increasingly low-yielding world, one in which close to $12 trillion of government debt outstanding is priced with negative yields, emerging-markets debt remains poised to attract further inflows in the global hunt for returns.
Supply and demand factors are supportive. Investors continue to add back exposure to emerging-markets debt, while issuance levels from EM sovereigns — excluding the Gulf states and Argentina — and corporates should be favorable to year-end. The ever-expanding universe of negative- and low-yielding government debt globally should push an increasing number of nondedicated emerging-markets debt investors into the asset class.
Idiosyncratic stories that are less correlated to global systematic risks also look interesting. Examples include Argentina sovereign credit. The prudent fiscal and monetary policy management evident since President Mauricio Macri took power in December seems likely to continue. In Brazil the change in presidential leadership has led to an improving macroeconomic story and the prospect of much-needed fiscal reform, while declining inflation pressure has created greater scope for the central bank to cut its benchmark rate, all of which are favorable for corporate credit and local currency rates.
Of course, there are still potential headwinds that could affect the asset class over the coming quarters — in particular, global growth and recession risks, political pressure points and China-related volatility. But we would use any episodes of market weakness as an opportunity to add exposure.
Investors in emerging-markets debt would be wise to focus on quality assets, such as those with stronger credit metrics and a more favorable risk profile. We believe these are the very first assets that will be targeted by global investors when seeking yield and exposure to emerging-markets debt.
Pierre-Yves Bareau is chief investment officer for emerging-markets debt at J.P. Morgan Asset Management in London.
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