Market Review

In August, hard-currency emerging market debt (EMD) returned +2.32% [1], while local-currency EMD returned +3.07% [2]. In EM corporate debt, the total return over the month was +1.69% [3].

In hard-currency EMD, there was a positive contribution from spreads, which tightened by 12 basis points (bps). US Treasury yields also boosted returns, as the 10-year yield fell by 13bps over the month to 3.90%. It was a particularly volatile start to the month as fears mounted about a US economic slowdown. Softer-than-expected non-farm payrolls for July came in at +114,000 (versus +175,000 expected), alongside downward revisions to the previous couple of months. The unemployment rate also increased to 4.3%. This triggered the Sahm Rule, indicating that a recession was under way as the three-month average unemployment rate had risen by 0.5% within the year. As a result, risk assets slumped, and the market quickly moved to price in a 50bp cut from the US Federal Reserve (Fed) in September.

Some more positive data on the US economy, including softer-than-expected initial jobless claims and robust retail sales, helped to calm fears of an imminent recession and provided a boost for risk assets. Later in the month, Fed Chair Jerome Powell’s speech at Jackson Hole confirmed that interest-rate cuts would be on the table in September, as policymakers did not wish to see any further softening in the labour market.

In local-currency EMD, the weaker US dollar led to a positive currency return (+1.97%). Local EM bonds (+1.08%) also helped performance, as yields fell by 11bps in August. In EM corporate debt, falling US Treasury yields and the tightening of spreads combined to generate a positive return over the month.

Outlook

EMD performed well in August, as fears of a US economic slowdown subsided and investors became more confident about future cuts to interest rates. We continue to see value in the high-yield (HY) and frontier markets due to attractive spreads and yields. These are supported by increased market access, continued multilateral support and progress on debt restructurings.

In EM local markets, we remain overweight in Latin America given the attractive real rates in the region. Additionally, lower economic growth and contained domestic wage pressures provide more room for central banks to cut interest rates. For EM corporates, credit fundamentals remain supportive and net supply is expected to remain negative as EM corporates continue to pay down bonded debt. As global economic growth slows, we are likely to see downward adjustments to operational performance. However, leverage levels remain low and interest coverage is healthy.

The asset class continues to offer good value versus developed-market credit, namely in HY. The ‘Goldilocks’ scenario for EMD would combine a more aggressive rate-cutting path for the Fed with slower US growth and a weaker US dollar. However, overtly weak US data could stoke recession fears, and that could trigger a wave of risk aversion.