Market review
In August, hard-currency emerging market debt (EMD)[1] returned -1.5%, while local-currency EMD[2] returned -2.69%. In EM corporate debt[3], the total return over the month was ‑0.44%.
In hard-currency EMD, there was a negative impact from US Treasury yields, with the 10-year yield rising 15 basis points (bps) to 4.11% over the month. The 10-year Treasury yield reached 4.36% at its peak, a level last hit in 2007. This was driven by a number of factors, including investors’ expectations that rates will remain higher for longer, with sentiment also impacted by ratings agency Fitch downgrading the US’s long-term credit rating to AA+. As well as concerns about large (and expanding) federal budget deficits. Spreads hurt returns; they widened by 24bps in August.
In local-currency EMD, foreign-exchange returns (-2.59%) were negative, as the US dollar recovered in August. Local EM bonds (-0.10%) also detracted from returns. In EM corporate debt, the widening of spreads negatively affected overall returns, as did rising Treasury yields.
Outlook
EMD markets weakened yet again in August, with core rates the major factor driving negative returns. However, spreads remained relatively contained, and are well below the levels seen during the US regional banking crisis earlier this year. Investors remain hopeful for an economic ‘soft landing’ and are increasingly pricing out the probability of a US recession. That said, the Chinese economy continues to weaken, casting doubt on the expectation (held earlier in the year) of a Chinese recovery lifting global growth. This presents a particular challenge for those countries with large volumes of exports to China.
The ‘Goldilocks’ scenario for EMD would combine the current expected path for US interest rates with the avoidance of an outright recession and a weaker US dollar. However, higher US interest-rate expectations and increasing financial stability risks could dampen investor sentiment and lead to more ‘risk-off’ conditions.
We believe selectivity is essential in the current market environment. We retain a preference for EM credits that are less reliant on imminent market access. We also continue to favour those with strong balance sheets and largely fixed-rate debt obligations. These characteristics should help limit exposure to the higher cost of capital, which is likely to prevail for many issuers for some time.
- 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)
- As measured by the JP Morgan CEMBI Broad Diversified Index