Fran Rodilosso, Head of Fixed Income ETF Portfolio Management, CFA
July 24, 2019
Lower interest rates in developed markets have been the key driver of emerging markets debt returns so far this year, despite several idiosyncratic stories and emerging markets central banks that have until recently exhibited an overall tightening bias. In our view, the shift in policy globally is creating a potential runway for emerging markets currencies (EMFX) to possibly fare better versus the U.S. dollar, and for emerging markets central banks to, partly as a consequence, take a more dovish stance with regard to their own interest rate policies.
The key question is whether current interest rate levels reflect fundamentals such as expected growth and inflation, or if they are being priced to expected central bank policy in the U.S. and Europe (which may or may not reflect economic fundamentals). We believe, if current rate levels are reflective of expected fundamentals, caution may be warranted. The negative impact to EMFX of slowing growth or an impending recession would likely outweigh the incremental benefit of lower rates to emerging markets local currency bonds. Spread sectors such as corporate bonds may also underperform as the credit cycle turns and spreads and defaults increase. In our view, a more benign “goldilocks”1scenario of continued slow growth supported by low interest rates, on the other hand, would be a more favorable environment in which we think investors may benefit from being tactical within these asset classes.
We believe that market expectations for lower rates are based on a view of central banks’ willingness to be extremely cautious about protecting growth and asset prices, and are not reflective of an impending end to the economic or credit cycle. If correct, this would be bullish for most asset classes and favor taking on more risk within fixed income portfolios. In this scenario, we believe emerging markets local currency bonds would fare particularly well. Many emerging markets central banks would have room to cut rates, potentially boosting local interest rate driven returns which have already provided the bulk of total return this year, while a weaker U.S. dollar could provide some lift to relatively stagnant EMFX returns. Even an environment of flat currency returns may be favorable for emerging market local currency bond investors, given the attractive carry the asset class currently provides with a yield of 6.7% as of June 30, 2019.
YTD EM Local Bond Returns Driven by Local Rates, While EMFX Has Lagged
Source: JP Morgan. Data as of 7/12/2019.
Emerging markets corporate bonds may also be attractive for investors not willing to assume currency risk, as returns will be anchored by U.S. rates while spreads may find support from central bank stimulus. We continue to favor the high yield segment of this market due to its attractive risk/reward in light of healthy and improving credit fundamentals.
1A goldilocks economy is an economy that is not so hot that it causes inflation and not so cold that it causes a recession.
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