It’s been a tough year for emerging market bonds. So far in 2018, the total return on emerging market (EM) debt issued in US dollars is negaive 3.4%, and EM debt issued in local currencies has fared much worse — down 9.6%. Meanwhile, high-quality US bonds are down about 1%. Some emerging markets do have major problems: Turkey, Venezuela, and Argentina have lost credibility with investors when it comes to battling inflation. But most EM economies are much better off than 10 years ago. This begs the question as to why all EM bonds have suffered this year. We think these two factors have created headwinds for the entire sector:
- Strength of the US dollar. The dollar has rallied in 2018, with most of the gain occurring since mid-April when trade war concerns took center stage. Year-to-date, the US dollar has appreciated roughly 5% (see chart above). A stronger dollar makes it more costly for emerging market countries to repay their dollar-denominated debt, and concern about even more strength in the dollar is what we think accounts for the bulk of underperformance in emerging market bonds.
- Risk aversion. Higher US interest rates and stronger economic growth have made US assets more attractive, especially amid talk of trade wars and the dire financial straits faced by a few EM countries, drawing investors away from emerging markets. Between February and June, there were net outflows from emerging market bond funds, reversing a bit in July. We think the August data will show net outflows again, due to developments in Turkey, which my colleague Josh Hile discussed in an earlier blog post, as well as Argentina, which earlier today hiked its interest rates to 60%, signaling a measure of desperation. Amid this “repricing of risk,” yield spreads have widened somewhat: Emerging market bonds issued in US dollars now yield 6.6%, on average. This is nearly 4 percentage points more than Treasury bonds with similar maturities, and 1 percentage point up from earlier this year.
So what do we see going forward? Most of our allocation to emerging market debt is denominated in US dollars. We think this relatively small position will provide value to LNWM portfolios in the next five years, for the following reasons:
- Relatively strong GDP growth: Emerging markets continue to grow faster than the US and other developed economies.
- Inflation under control: EM central banks have gained credibility in controlling inflation, with some notable exceptions (Turkey, Argentina, Venezuela).
- Less dependence on foreign funding: Most major emerging markets now run only a small deficit in investment flows (capital account deficit).
- Much less reliance on commodities: In 2009, 30% of EM stock market value was commodities-related while less than 14% is today.
- Broader, more liquid markets: In the past 10 years, the size of the EM government debt market has doubled; corporate debt market has tripled.
- US dollar rally likely to stall: The potential for trade wars is likely to dissipate since all sides are motivated to reach agreement (with Mexico a recent positive example). In addition, the high US trade and budget deficits are likely to keep a lid on US dollar strength.
- US interest rates likely to rise gradually: Demand for higher-yielding assets is likely to continue due to macroeconomic and demographic factors, although at potentially lower levels. As trade war concerns subside, emerging market bond yields are likely to become more attractive to investors.
- Higher EM credit quality: Approximately half of all emerging market bonds are now rated investment-grade. Because of this, the yield spread with US Treasuries should be closer to 2 percentage points vs. nearly 4 points currently.
- Relatively low EM default rates:The default rate among emerging market bonds has been lower than that of US high-yield corporate debt.
- Persistent after-tax yield advantage: After-tax yields on emerging market debt are 1.5 to 2.5 percentage points higher than comparable US municipal bonds.