Market review
In July, hard-currency emerging market debt (EMD)(1) returned +1.91%, while local-currency EMD(2) returned +2.88%. For emerging market corporate debt(3), the total return over the period was +0.98%.
In hard-currency EMD, there was a big positive contribution from spreads, which tightened by 29 basis points (bps). This comfortably exceeded the negative impact from Treasuries, with the US 10-year Treasury yield up 12bps to 3.96%. Higher treasury yields were reflective of the strength of recent US economic data, which hardened expectations for additional US monetary tightening. Indeed, a further US rate hike of 25bps took place on 26 July, taking the fed funds rate to a target range of 5.25%-5.50% - a 22-year high.
In local-currency debt, continued outperformance relative to the other main EMD segments was largely driven by FX returns (+2.11%), with EM currencies strengthening against the US dollar in July. There was also a smaller but significant contribution from the performance of local EM bonds (+0.75%). In EM corporate debt, the positive overall return was due to spread compression of 19bps. As was the case for hard currency sovereign bonds, this outweighed the negative impact of higher Treasury yields.
Outlook
Although core rates moved higher again, July was still a good month across the board for EMD. Looking ahead, concerns about the economic outlook in developed markets could see corporate earnings weaken and spreads move to price in a recession. This could hurt EMD relative valuations. However, worries of a US recession have been lessening of late. Instead, given the strength of recent US data, the greater risk could be that of further Fed rate hikes, beyond what is priced in.
Softer data coming out of China means that the potential upside risk of a stronger China recovery seems less likely. The ‘Goldilocks’ scenario for EMD would combine the current expected path for US interest rates, along with a ‘soft landing’ for the economy, resulting in weaker US growth (but no recession) and a softer US dollar. On the other hand, the two scenarios that could lead to more risk-off conditions are upwardly revised US policy rate expectations and markedly increased financial stability risks.
We think the current environment calls for a high degree of selectivity, with a preference for EM credits that are less reliant on imminent market access. We also favour credits with more robust balance sheets and largely fixed-rate debt obligations. These factors should help limit their exposure to the higher cost of capital, which is likely to prevail for many issuers for some time.
- As measured by the JP Morgan CEMBI Broad Diversified Index
- As measured by the JP Morgan EMBI Global Diversified index
- As measured by the JP Morgan GBI-EM Global Diversified index (unhedged in US dollar terms)