Weekly Bond Bulletin

18 June 2020

Searching hard for EM value

As the global economy gradually recovers, the outlook for growth in emerging markets is improving. Could hard currency emerging market debt present opportunities?

Fundamentals

As in developed markets, the emerging market (EM) recovery is underpinned by policy action: central banks in emerging markets have delivered decisive monetary easing, while governments have enacted unprecedented fiscal stimulus. Now, a modest recovery appears to be starting in China, where factories are beginning to reopen and manufacturing activity is picking up. The resultant demand for commodities and raw materials should have a positive effect on the broader EM complex. With that said, the path of the virus remains a key risk to monitor, and while the situation looks reasonably stable from a developed market perspective, there are clearly a number of countries across emerging markets (particularly in Latin America and the Middle East) that are not out of the woods yet. Heightened infection rates could lead to another round of lockdowns and significant stress on healthcare infrastructure, hampering the EM recovery.

Quantitative valuations

Emerging markets have been carried along with a broad-based risk rally over the last quarter, with returns of 19%, 14% and 16% for EM local, hard currency sovereign and corporate indices respectively since 23 March. This prompts questions about where the value remains. We hold a favourable fundamental view of investment grade (IG) hard currency sovereigns, but this is a subsector that has rallied particularly hard, with spreads having retracted more than 70% of their widening, to 216 basis points (bps). That leaves high yield sovereign credit looking relatively attractive, with only a 50% retracement to 817 bps. Other areas also look attractive, such as IG corporates, which trade at a spread of 266 bps, though the market is less liquid than some other subsectors so investors need to be prepared to take a longer-term view. (All data as of 17 June 2020).

Some EM hard currency credit flags as cheap, especially relative to developed markets

Source: Bloomberg, JPMorgan Chase & Co; data as of 17 June 2020. EMBI = JPM Emerging Market Bond Index Global Diversified (hard currency sovereign credit); CEMBI = JPM Corporate Emerging Market Bond Index Broad Diversified (hard currency corporate credit); HY = high yield; IG = investment grade.

Technicals

The recent rally appears to have been driven by dedicated EM investors, who moved to defensive positioning at the height of the crisis, and have since redeployed most of their cash across the asset class. Demand more broadly has yet to fully return, with crossover investors apparently remaining lightly positioned. This is reflected partly in the huge weight of capital still held in both institutional and money market funds, which we highlighted last week. These holdings will not all flow into financial assets, but they do suggest that there is at least some cash ready to be deployed. Furthermore, central bank purchases have driven broad-based demand for developed market credit. As spreads continue to grind tighter, it is possible that yield-hungry investors will turn their attention to emerging markets.

What does this mean for fixed income investors?

The Covid outbreak needs to be closely watched, since it will directly impact the resumption of economic activity in emerging markets, which will drive oil demand and fuel the growth recovery. The strength of the technical support for fixed income markets globally is likely to benefit emerging markets sooner or later – but the challenge will be to find the sectors that still present value. High yield EM sovereigns currently look attractive relative to higher quality names, while, in the corporate space, high quality issuers may also present opportunities for long-term investors.

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.

Click here to read more about our FQT capabilities


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18 June 2020
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