Weekly Bond Bulletin

7 January 2021

Emerging into 2021

With positive vaccine sentiment continuing to drive a risk-on mood, emerging markets still look like the place to be.

Fundamentals

Covid-19 infection rates continued to rise sharply over the holiday period, forcing many countries to tighten restrictions further. However, markets are largely brushing this off and looking ahead to a post-Covid world as vaccines start to be rolled out. Israel is leading the pack so far, with nearly 15% of the population already vaccinated, including 100% of those aged over 80. The key risks are twofold. First is that the vaccine continues to be distributed more slowly than initially expected. So far this is particularly true for Europe, where a large share of the vaccine supply is not yet approved, vs. the US, where the rollout has been relatively smooth. Second is the risk that vaccine efficacy depletes, because of a new virus variant, for example. Following the success of the Democratic candidates in the Georgia Senate run-offs, investors are also evaluating the implications of Democratic control of the Senate, such as additional fiscal stimulus and tax hikes. Benchmark 10-year US Treasury yields have surpassed 1% for the first time since March and we expect them to continue to rise, but they shouldn’t shoot up too quickly. A gradual rise is likely to support a weaker US dollar and stronger growth in emerging markets, where the economic recovery is becoming more broad based. December’s Markit emerging markets manufacturing purchasing managers’ index print of 52.8 exceeded pre-Covid levels, with 76% of countries in expansionary territory (above 50) and 53% above their previous prints.

Quantitative valuations

From a valuation standpoint, emerging markets still look like the place to be. Headline hard currency spreads stand at 350 basis points (bps), some way off the 289 bps level at which they started last year. On a relative basis, the sector looks attractive vs. the likes of global investment grade corporates, which have a current spread of 100 bps. Value is not evenly distributed across emerging markets, though: investment grade markets, on the whole, are trading quite tight on a historical basis, at 147 bps, whereas high yield countries look better, at 607 bps. Of course, high yield countries have their ratings for a reason, and it pays to be selective. Emerging market (EM) curves on the whole are steeper than developed and offer more roll down. To us, Mexico, South Africa and Indonesia look appealing, with relatively steep curves, especially at the long end, alongside decent real and nominal yields, dovish central banks and high growth prospects. (All data as of 5 January 2021.)

Emerging markets generally appear to offer more value than developed markets

Source: Bloomberg, J.P. Morgan Asset Management; data as of 1 January 2021. Percentiles use five-year history; 2s10s local bond slope is the local currency 10-year yield minus the two-year yield.

Technicals

As investors continue to grab for yield, flows have been pouring into EM funds in recent months, with December inflows alone reaching over USD 6 billion. However, the extent of the March outflows means net flows for 2020 as a whole were only slightly positive, at USD 3.3 billion. We can draw from this that EM debt is becoming more of a consensus trade but could still have some way to go. Issuance is expected to pick up, but should be digested well as flows start to come not only from dedicated EM investors but also from tourists.

What does this mean for fixed income investors?

Overall, the backdrop is supportive for emerging markets, with growth expected to improve this year after a dismal 2020. To some degree, the trade has already drawn attention, but we expect flows to carry on trickling in as investors scour global markets for ways to hit their yield targets. The extent to which this positive outlook holds together is largely dependent on US rates. Investors need to watch the pace at which 10-year Treasury yields creep up, with a gradual move more favourable than a rapid rise. Selectivity will also be important. While steeper curves and higher yields vs. developed markets may look relatively appealing, picking the countries that also exhibit more stable and improving fundamentals should end up being more rewarding.

About the Bond Bulletin

Each week J.P. Morgan Asset Management’s Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.

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7 January 2021
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