In a banner year for capital markets, emerging-market debt (EMD) posted healthy double-digit returns. Global central bank easing, among other supportive factors, helped drive a broad-based rally across nearly all emerging-market (EM) countries. Can this strength continue through 2020?
We think it’s unlikely that returns will be as robust in 2020. EM and other bond investors will face a number of systemic risks in 2020—from a fraught geopolitical landscape to a global slowdown—underscoring the need to be more discerning. In the year ahead, the differences between EMD winners and losers will likely be marked.
On the other hand, we don’t see a dramatically darkening picture. Not only does the asset class offer attractive yield relative to developed-market (DM) debt of comparable quality, but we also expect most major influences on EMD performance to remain supportive.
Key Influences on Emerging-Market Debt
Let’s begin with a key risk that is mostly behind us. Last year was an important one for EM elections, which have the potential to disrupt policy and unsettle investors. Thankfully, most of 2019’s elections ran smoothly. In 2020, the main electoral risk comes from outside EM: specifically, the US presidential election.
In addition to a potential impact on global risk sentiment, the outcome of the US election in November could also affect other global factors, including US Federal Reserve policy. For now, the central bank has paused in lowering rates, but we believe the balance of risks is skewed toward further easing, which supports EM assets.
The US dollar traded in a very narrow range in 2019. We see few reasons for this to change in 2020. That said, any signs of a weakening US dollar would provide EM with a substantial boost, particularly on the currency side. December’s strong EM currency rally shows what can happen in a risk-on environment in which the US dollar weakens. We monitor such scenarios closely.
As for trade tensions, the US administration will likely continue to talk tough on trade but refrain from sparking more major conflicts ahead of the election. This stance gives room for Beijing to continue to manage China’s economic growth.
We expect Chinese real GDP growth to slip slightly to 6.0% in 2020 and to 5.8% in 2021. The People’s Bank of China will counter any downside pressure, including the potential impact of the Wuhan coronavirus, with further monetary and fiscal policy easing and with major infrastructure investment. These policies are a stabilizing force for EMD.
Given this backdrop, we advocate selective EMD investment in 2020.
Emerging Markets on the Rise
Improving measures of quality and current valuations support this view.
EM growth prospects look attractive today relative to those of DM, with some key EM countries now in the early stages of a cyclical recovery. We forecast EM GDP to grow at 4.4% in 2020—almost four times the rate of industrialized countries, at 1.2%. We expect easy monetary policy to continue across the developed world, while aggregate EM inflation levels stay low. This scenario would provide headroom for further rate cuts by some EM central banks. (We think it’s unlikely there will be a repeat of the broad-based EM easing of 2019.)
After the collapse in trade last year, the recent phase-one US–China trade deal alleviates concern about a near-term flare-up in the trade war, while also reducing uncertainty more broadly. Early signs of stabilization in global economic data are also promising for EM.
While the rise of populism increases investment risk globally, and like several other factors points toward selectivity in 2020, we’ve seen positive reforms in some EM countries. One of the most comprehensive reform packages was in Brazil, where the centerpiece reform to the country’s pension system was accepted without unrest.
EM external public-sector debt levels, though rising in absolute terms, have declined since 2012 when viewed as a percentage of GDP, net of currency reserves. Since 2015, they’ve been stable. In addition, as EM countries develop deeper and more liquid local debt markets, they increasingly fund their borrowing needs in local currencies. Local funding has increased resilience and lowered contagion risk, as it reduces EM borrowers’ exposure to currency crises.
In particular, EM economies are less vulnerable to external shocks than in the days of the taper tantrum, thanks largely to improving current account balances and stable foreign direct investment (FDI). Display 1 combines EM current account balances with FDI flows—typically a stickier, multiyear commitment—into EM countries. This “basic balance” measure provides a fuller (and today, a healthier) picture of EM countries’ external vulnerability. Notably, this is an aggregate measure, and pockets of weakness certainly remain—another reason why it will be important to be selective in 2020.
As investors have become more discriminating in their EM country appraisals, we’ve seen improved stability for higher-quality issues and resistance to contagion from high-yield into investment-grade EM during periods of weakness. Similarly, across investment-grade issues, improved quality has manifested in a trend toward convergence in both the credit ratings and the volatility of EMD and DM debt. In fact, corporate leverage, which is lower in EM than in US investment-grade debt, has declined further in recent years, while US debt levels have deteriorated.
Lastly, while real DM bond yields are near record lows, EM local yields provide a significant income advantage to yield-starved investors (Display 2). This yield advantage could be a powerful driver of flows in the coming year. Indeed, with both sovereign and corporate EM issuance likely to remain in line with 2019 levels, inflows could also be a major driver of performance.
Four Takeaways for 2020
EMD doesn’t come in just one flavor. Investors employ different kinds of EMD (and combinations thereof) to different purposes, and different kinds of EMD are subject to varying influences. Here are our takeaways today for the main variants:
Hard-currency EMD: Hard-currency EMD spreads—both sovereign and corporate—tightened in 2019. As a result, many bonds appear expensive relative to historical levels. But investors should keep in mind both the changing composition of the sovereign index and relative value compared with DM.
First, J.P. Morgan phased Venezuela (as well as state-owned oil company PDVSA) out of its flagship indices in 2019. Quoted yields were high but inaccurate, as neither Venezuela nor PDVSA had paid coupons for some time. In addition, extremely low liquidity and US sanctions on PDVSA has almost completely halted trading.
Second, with the inclusion of the Gulf Cooperation Council (GCC) region, the composition of the hard-currency sovereign index changed meaningfully in 2019. This region includes several large, high-quality, Middle Eastern issuers whose bonds offer relatively lower yields.
The result of these exclusions from and inclusions in the index has been an overall decline in spread and concurrent increase in quality. Nevertheless, hard-currency EMD continues to offer a meaningful yield pickup over DM bonds of comparable quality. We believe that this dynamic will anchor flows into the asset class.
Local-currency EMD: Within local-currency EMD, we prefer hedged exposure in countries with steep local yield curves or where we expect additional monetary policy easing in 2020. While most EM central banks have finished loosening policy for now, we expect to see more easing by others. Again, selectivity is the name of the game for 2020.
EM corporates: EM investors should consider allocations not only to EM sovereigns—both hard and local currencies—but also to EM corporate bonds. Corporate default rates will likely remain below historical averages across most EM, with the notable exception of China. We have started to see signs of onshore Chinese defaults picking up—a trend we expect to continue as the country transits its credit cycle.
High-yield EMD: Today, we favor high-yield over investment-grade EMD. A sharp sell-off in August left the EM high-yield market looking relatively cheap. Investors should consider balancing more defensive high-yield sovereign credits against select positions in countries with higher yields and more idiosyncratic risks. To this end, we focus on the size of countries’ external and fiscal funding gaps, and the extent to which this will affect bond price performance in the year ahead. Bonds issued by countries with large gaps are more likely to struggle.
The Right Emerging-Market Debt Strategy for 2020? Dipping, Not Diving
EMD investors who advantageously dove into the market in 2019 may find that now is the time to surface but not to dry off. If 2020 sees greater divergence between EM opportunities, as we expect, then the key to successful emerging-market debt investing will be deep research and a selective approach.
Shamaila Khan is Director of Emerging-Market Debt at AB.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.