The US debt ceiling discussion introduced volatility again and drove US treasury yields higher across the curve. Now with the issue largely behind us, all eyes are back on growth-inflation dynamics in the US and the remaining appropriate US monetary policy path that will put the inflation genie back in the bottle for good. While the Fed paused its rate hike in its latest June meeting and whether there will be any further rate hikes will be data dependent, we take the view that we are near the end of the US monetary policy hiking cycle but will not see any Fed rate cut for a prolonged period.
For emerging market debt, the second quarter to date performance has been positive, albeit less stellar than the first quarter across all sub asset classes, with emerging markets (EM) Hard currency sovereign delivering 1.06%, EM Hard Currency corporate delivering 0.9% and EM Local currency sovereign delivering 1.93%, based on JP Morgan indices. During this period, both sovereign and corporate spreads have compressed, by around 30 and 15 basis points respectively. Emerging market foreign currencies have delivered largely flat returns against the USD at the aggregate level, whereas local rates have delivered more meaningful positive returns. (Data as 12th of June, JPM)
Fundamental Perspective
Looking ahead, from a fundamental perspective, we continue to keep a close eye on inflation, growth, China and refinancing risk of EM.
Inflation
Headline inflation has come down in most EM countries, whereas core inflation is somewhat sticky in certain areas, such as Central Europe, due to tight labor markets. EM countries have led the monetary policy hiking cycle by hiking early; nevertheless they are showing prudence again by not cutting prematurely, often leading to attractive carry profiles.
Growth
Growth remains challenging for EM in general but we see healthy pick up of EM growth over developed markets (DM) growth. The IMF’s latest forecast for 2023 GDP points to 4% GDP growth in EM vs 1.2% GDP growth in DM. Furthermore, we see agricultural-driven economies doing better, such as India and Brazil. Given the current high monetary policy rates, EM growth is showing remarkable resilience. For example, Brazil’s policy rate is currently at 13.75% whereas forecasted 2023 GDP growth is around 1.2%.
China
After strong first quarter China economic data, second quarter to date data have turned much weaker. Sentiment is rather bearish on whether China can achieve its 5% 2023 GDP growth target. We think there is room for monetary policy easing and fixed asset investment to help support growth and sentiment domestically. However, this means that we think China will not deliver meaningful growth or inflation impulses for the rest of the world, as China continues to rebalance its growth model.
Refinancing
Last but not least, refinancing risk remains one of the most important factors for our credit differentiation analysis, given the tightening financial conditions. In the EM sovereign space, we believe some Sub-Saharan countries will remain challenged. In our meeting with the IMF last month, we discussed that sovereign default situations and restructuring solutions will have to be case dependent. For example, Zambia opted for the G20 common framework which involves a relatively long negotiation process with multiple external debt creditors, whereas Ghana chose to restructure its domestic debt first and swiftly. We have also agreed with the IMF’s view that currently there is little contagion risk from sovereign defaults. In the EM corporate space, as a result of prudent balance sheet management over the years and positive impact of commodities on the asset class, we do not see “higher rates for longer” being acutely challenging for the asset class yet. Nevertheless, we are starting to see some deterioration in corporate fundaments, resulting in our somewhat cautious approach to the asset class. We see credit differentiation a key theme for rest of the year. We see some value in the high yield segment but remain vigilant when it comes to companies with large near term refinancing needs. We look for issuers with evident balance sheet strength.
Valuation Perspective
Valuation is the other important consideration. For both EM sovereign and corporate Investment Grade, the spreads signal little value. There are some structural reasons for the tightness of the spreads, such as strong and sticky ownership in Asia with limited supply, and migration of high quality Gulf Cooperation Council (GCC) credits into the investment universe. Furthermore, once we adjust for duration, especially in the case of EM corporates, the valuation becomes more compelling relative to other investment grade asset classes. High Yield spreads look more attractive. However, for EM sovereigns, if we exclude CCC rated countries the valuation becomes more neutral. EM high yield corporate spreads signal attractive valuation relative to US high yield across all ratings; nevertheless we focus on higher rated EM corporates within high yield. We particularly like EM rates currently, given the large monetary policy hike conducted and the relatively benign inflation outlook forward. For example, in Brazil the latest inflation print in May was 3.94%, offering significant positive real yield of almost 9%.
Outlook
Looking ahead, while we maintain our outright cautious stance in the late cycle environment, we have started to reduce our underweight of risk on the back of recent encouraging US data and emerging market economies continuing to show resilience. For example, in Hard Currency sovereign, we have added risk in Nigeria and Egypt due to improvement in their country fundamentals and we have taken profits in high quality GCC credits. In EM corporates, we continue to like Indian Renewables. Gross Gaming Revenue (GGR) is picking up in Macau gaming whereas valuation has not fully caught up with the better than expected fundamentals. We also like the defensive utility sector, whereas we remain cautious on Chinese real estate. We are being selective in Latin America and Africa corporates because of the increased political noise in the former and difficult market access in the latter. In EM local currency markets we like Brazil, Mexico and Indonesia, while maintaining our neutral stance of aggregate EM FX risk vs the USD.
Figure 1: CREDIT RATING ADJUSTED, ALL EMERGING MARKET DEBT SUB ASSET CLASSES OFFER ATTRACTIVE YIELDS, EXCEPT EM CORPORATE IG
However, once we adjust for duration, we believe the yield for EM Corporate IG becomes more compelling relative to Global IG and US IG.
Figure 2: DURATION-ADJUSTED YIELDS
Source Disclosures
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DEFINITIONS
DM: Developed Market. DM countries include: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States.
EM countries include: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Kuwait, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
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
ICE bofa Global High Yield Index ─ tracks the performance of USD, CAD, GBP and EUR denominated below investment grade corporate debt publicly issued in the major domestic or eurobond markets.
ICE bofa Global Investment Grade Index ─ tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market. You cannot invest directly in an index.
ICE BofA US High Yield Index ─ ICE BofA Merrill Lynch US High Yield Index (H0A0) tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.
ICE BofA Euro High Yield Index ─ The ICE BofA Euro High Yield Index tracks the performance of EUR denominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets.
ICE BofA Euro Investment Grade Index ─ tracks the performance of Euro denominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets.
ICE BofA Global Broad Market Index ─ The ICE BofA Global Broad Market Index tracks the performance of investment grade debt publicly issued in the major domestic and eurobond markets, including sovereign, quasi-government, corporate, securitized and collateralized securities.
ICE BofA Investment Grade US Convertible Index ─ The ICE BofA US Convertible Index tracks the performance of publicly issued US dollar denominated convertible securities of US companies
ICE High Yield & Unrated Large Deal Municipal Bond Index ─ The ICE High Yield & Unrated Large Deal Municipal Bond Index tracks the performance of U.S. dollar denominated high yield tax-exempt debt publicly issued in the U.S. domestic market by U.S. states and territories as well as their political subdivisions.
J.P. Morgan CEMBI Broad Diversified High Grade Blended Yield Index ─ The J.P. Morgan CEMBI Broad Diversified High Grade Index is a sub components of the J.P. Morgan CEMBI Div Broad Composite Blended Yield Index, which covers the investment grade parts of this composite index.
J.P. Morgan CEMBI Broad Diversified High Yield Blended Yield Index ─ The J.P. Morgan CEMBI Broad Diversified High Yield Index is a sub components of the J.P. Morgan CEMBI Div Broad Composite Blended Yield Index, which cover the sub investment grade part of this composite index.
J.P. Morgan CEMBI Div Broad Composite Blended Yield Index ─ The CEMBI Broad Diversified Composite is a comprehensive USD corporate emerging markets bond index that employs a unique approach which uses only a certain portion of the current face amount outstanding for instruments from countries with larger debt stocks. This helps to limit country weights, while reducing index turnover, when compared with the 10% hard-cap approach employed by the GBI-EM series.
J.P. Morgan EMBI Global Diversified Index ─ The J.P. Morgan EMBI Global Diversified Index (EMBIG) tracks liquid, US Dollar emerging market fixed and floating-rate debt instruments issued by sovereign and quasi-sovereign entities.
J.P. Morgan GBI-EM Global Diversified index─ 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.
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