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Cycling into Emerging Market Sovereigns

10 September 2019

Bond yields have nose-dived once more this summer in light of renewed geopolitical tensions and a decelerating global economy. GAM Investments’ Bogdan Manescu believes that fixed income investors can still find value and attractive yields in emerging market (EM) sovereign, hard currency issuance.

Exploiting cyclical opportunities in the EM hard currency bond space

It has proved a troubling summer for investors, with geopolitical anxieties intensifying and fixed-income yields descending once more in response to safe haven-seeking capital flows, but it is not all doom and gloom. Emerging market (EM) sovereign hard currency bonds, as measured by the JP Morgan EMBI Global Diversified Index, have delivered double-digit returns (USD) on a year-to-date basis1 and have outperformed US 10-year treasuries. The declining level of US yields has been a key factor in this outperformance, but it is still a remarkable result given it has been achieved against a backdrop of diminishing global growth and trade skirmishes of various intensities between the big economic blocks of the US, China, the EU and Japan – therefore bucking the normal trend of EM assets being the first to suffer in a typical risk-off environment.

The signs are not encouraging, but…

In the most recent Federal Reserve (Fed) hiking cycle of 2015-2018, US yields began their downtrend before the shift in Fed rhetoric and have declined considerably more than the adjustment to the official Fed Funds Rate. The benchmark 10-year US Treasury peaked at 3.23% in early November 2018, while the Fed implemented its final hike of the cycle at its December meeting. Since then, the US 10-year yield has slipped below 1.5%, while the Fed has only thus far implemented a 25bps cut (in July) to bring the range of ‘Fed Funds’ down to 2.0-2.25%. Furthermore, having teetered on the brink for a while, the 2-10 year yield curve inverted once more in late August, which has long been considered a portend of recession. Some commentators appear to be weighing up the impact of the trade war alongside the waning influence of the short-term impulse provided by the 2017 Tax Cuts and Jobs Act, concluding that a recessionary outcome is all but inevitable.

However, it could also be argued (based on observed market reactions to news on the trade front) the decline in US yields across the entire maturity spectrum is more related to uncertainties in respect of trade wars and the associated economic weakness, rather than being a reflection of earlier and excessive monetary tightening increasingly placing a stranglehold on the economic cycle. The latter scenario demonstrably prevailed in 1994 / 95, when the Fed hiked on no fewer than seven occasions in the space of 12 months, taking the official rate from 3% to 6%, and in the hiking cycle of 2004-2006. Fed policy has clearly been more measured this time around and bond investors anticipate that the central bank will continue cutting in order to support the global economic environment. If these expectations come to fruition, a dovish Fed might reverse the curve inversion, while any final agreement on the trade front between the US and China should stimulate a steepening of the curve. One thing that is more certain is that continued unpredictability is likely to test investors’ nerves on a regular basis.

Not exactly a ‘natural’ hedge…

The signals emanating from EM sovereign hard currency bonds regarding the probability of a US recession are also not clear cut. EM sovereign hard currency bonds are hardly a natural hedge against a global economic slowdown. The most recent performance of the non-investment grade rating categories was in line with any other growth-sensitive bond asset class. The spread of these low rated countries has widened and stand at 439bps2. Conversely, the message sent from the movements in higher quality, investment grade EMs is more contrary: EM IG spreads are on the lower side of their historical range, at 165bps2. The JPM EMBIG Diversified Investment Grade Index has delivered a return of 16.61% this year3, outperforming the FTSE 10-Year Treasury ‘on-the run’ benchmark return by 4.20% over the same timeframe. In August alone, this particular EM segment has delivered a 4.15% appreciation, which is hardly indicative of an upcoming global recession.

Chart 1: EM sovereign spreads do not indicate a global recession

Source: JP Morgan, Bloomberg as at 30/08/2019. For illustrative purposes only.

Past performance is not an indicator of future performance and current or future trends.

From a valuation standpoint the current spread differential between the high yield and the investment grade segment of the EMBI Global Diversified is close to its historical high of 499bps; similar to the levels witnessed on 27 October 2008 at the height of the financial crisis (chart 1).

Even if the proportion of developed market rates trading at sub-zero yields declines, the demand for positive-yielding assets with fundamentally sound metrics is here to stay in the prevailing environment. Temporary cyclical set-backs in the EM asset class due to an unpredictable outlook of the trade war are only to be expected, as EM economies have proved a primary beneficiary from globalisation. Nevertheless, the fundamentals of EM countries have improved in recent years, as illustrated by the prudent stance reflected in their increasing FX reserves (chart 2) across EM countries, which is at all-time highs.

Chart 2: Increasing FX reserves are a sign of EM prudence

Source: IMF, National Sources, Eikon; FX Reserves = Total Reserves excl. Gold; USD; Ex China, Hong Kong; latest available data to July 2019. For illustrative purposes only.

Past performance is not an indicator of future performance and current or future trends.

Grounds for EM investment conviction…

In conclusion, we have firm reasons to believe that, given a reversal of the quite bearish sentiment priced in the developed markets, the higher-yielding EM segments should outperform the high-quality segments once more. This is not so much an opinion or a forecast, but a measured view based on historical comparison and observed market reactions. From our perspective, this constitutes a cyclical opportunity to invest in hard currency EM sovereigns. We believe the best way to harness such opportunities is to focus on observable, economic fundamentals in each country. From here, we will take a medium-term assessment of relative creditworthiness and maintain our valuation-driven investment process, which we have been refining for more than a decade.

1As of 30 August 2019.
2As of 30 August 2019.
3As of 30 August 2019.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.