Hard currency sovereign bonds rose by 1.76%, corporate bonds by 3.29%, and local currency bonds, when measured in US dollars, by 4.28%.1 The largest contributions to returns for all asset classes derived from the interest component. Capital gains from contracting risk premiums were confined to specific countries or corporate credits, while the contribution from the US treasury component was marginally subtractive. Specifically for local currency markets, the contribution from interest rates outweighed the return generated from stronger currencies overall. The inflationary impetus from higher energy costs and mangled supply chains after Covid-19 restrictions were lifted are now fading, resulting in a relatively stable environment for emerging market bond yields. So-called second round effects, when workers demand higher wages to compensate for rising prices could still keep inflation higher than in previous cycles, but recent data releases point to a softening labor market. These trends have evolved at different speeds in different regions and across developed and emerging markets, but overall moderating consumer prices have now engulfed almost all countries. Central banks, in the late stages of policy interest rate adjustments already, are signaling an imminent pause. In some emerging markets, where policy makers have reacted early to the inflationary threat, rate setting committees are now in a position to start lowering interest rates amid precipitously falling inflation.
The outlook for China is still among the most cited investor concerns. Convergence in nominal GDP with the United States has stalled on account of falling prices, a feeble currency and weaker growth. The softening yuan however has not yet boosted exports; the latest data released for trade with the rest of the world has shown a drop in the proceeds from goods sold abroad. Domestically the economy is suffering from a slump in real estate. Within the sector, private property developers have defaulted on many dollar denominated obligations, closing an important avenue for refinancing existing debts. Consumer sentiment is weak, imperiled by falling housing prices, and youth unemployment rose to such heights that the Communist Party chose to stop publishing the figures. However, Chinese authorities have begun to announce several, often surgically targeted measures to boost the domestic economy in very specific ways. In our view this is consistent with the stated objective to improve the quality of growth, but if the strategy is successful, it could cocoon the country further inward. As a result we don’t expect Chinese economic activity to permeate as strongly outwards as it had in the past; the contribution to global growth from Chinese demand might diminish over time. More immediately, Chinese demand for commodities, particularly those needed for homebuilding will likely remain sluggish. For investors however, Chinese bond markets offer some very interesting opportunities, often entirely unaffected by the woes of property developers. Even more so, the strategic repositioning of growth and its inward orientation can give rise to new investment ideas within China and its surrounding regions; for example, the gaming sector in Macao, some sectors in Hong Kong or specific corporate credits in Indonesia and Malaysia.
The growth outlook for emerging markets has markedly brightened as the year progressed, despite the headwinds from China. We think this resilience bodes well for returns going forward and are further encouraged that drivers of higher growth are well diversified. We note that, apart from the obvious beneficiaries from higher crude oil prices, agriculturally oriented economies have performed well in recent quarters. Furthermore, the rebound in travel and tourism has helped services sectors across many emerging markets. Concerns over tightening financing conditions warrant close attention, but we are encouraged by the creativity of many borrowers, for example greater reliance on local funding options. The relative shift in interest rates, where the low inflation environment in Asia for example has compressed the yield differential with the United States and Europe, has fueled an uptake in domestic borrowing.
From a flow perspective, 2023 has been very unusual. Normally, investor appetite for emerging market bonds is closely correlated with performance, where in negative total return years investors withdraw funds from the asset class often exacerbating drawdowns, while in positive return years investors subscribe. This year so far, using flow information from the EFPR database, the asset class has seen outflows for over 80% of the weeks data was available, despite positive returns. This relationship of positive returns and outflows held true only once in the last 15 years, during the recessionary year of 2015, where a precipitous fall in commodity prices led to significant growth slowdowns across many emerging markets, while returns in absolute terms were positive owed to a strong rally in US treasuries. Overall we think that amid the growth outperformance for emerging markets, the resilience in financing and the more stable yield environment, a return of strategic inflows is all but a matter of time.
1. Source: JP Morgan as of September 29th, 2023.
Hard currency sovereign bonds: The JP Morgan Emerging Market Bond Index Global Diversified – Total Return; Corporate bonds: The JP Morgan Corporate Emerging Market Bond Index Broad Diversified – Total Return; Local currency bonds: The JP Morgan Government Bond–Emerging Market Index – Total Return in USD.
Please see disclosures for index descriptions.
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COMPARISONS TO AN INDEX
Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, individual portfolios are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.
Index Descriptions
JP Morgan Emerging Market Bond Index Global Diversified – Total Return ─ The J.P. Morgan Emerging Market Bond Global Diversified Index (EMBIGD) tracks liquid, US Dollar emerging market fixed and floating-rate debt instruments issued by sovereign and quasi-sovereign entities.
JP Morgan Corporate Emerging Market Bond Index Broad Diversified – Total Return─ The J.P. Morgan CEMBI Broad Diversified tracks the performance of U.S. dollar denominated corporate emerging market bonds where the issuer is headquartered in either Asia ex Japan, Latam, Eastern Europe, or Middle East/Africa.
JP Morgan Government Bond–Emerging Market Index – Total Return in USD─ The J.P. Morgan GBI-EM Global Diversified index is comprised of local emerging market government bonds. For a country to be eligible for inclusion in the index, its GNI per capita must be below the Index Income Ceiling (IIC) for three consecutive years. JPMorgan defines the Index Income Ceiling (IIC) as the GNI per capita level that is adjusted every year by the growth rate of the World GNI per capita, Atlas method (current US$), provided by the World Bank annually.
USE OF ISSUER NAMES
Issuer names used herein are provided as examples for educational and illustrative purposes only and are not intended, nor should they be construed as, recommendations to buy or sell any individual security.
Information included herein should not be considered predicative of future transactions or commitments made by MacKay Shields LLC nor as an indication of current or future profitability. There is no assurance investment objectives will be met.
Past performance is not indicative of future results.
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