The Upside of EM and Corporate Debt

Text transcript

Robert Abad, Product Specialist, Western Asset Management.

Emerging markets flew right into a perfect storm last year, and this caused investors to flee en masse. As if the fear of more Fed rate hikes and higher treasury yields wasn’t enough, the US dollar also moved higher, especially against the emerging market currencies which really battered the asset class. It also didn’t help to have headline noise around trade wars and tweets from the Trump administration bashing China or our strategic allies, and there were also election risks in Mexico and Brazil, and these are typically the markets where most investors have their exposure.

Now, EM has been a high conviction call for us, so we’re very pleased to see the sharp recovery in EM spreads and currencies over the past few weeks. Now looking ahead, we think the outlook for emerging markets still remains positive. We’re still seeing growth momentum across the major economies. Inflation trends look stable. And central banks are looking to cut rates now after pushing them higher last year to stabilize their currencies. Now valuations across emerging markets are also very attractive. For example, if you look at index yield spreads between emerging and developed market debt, they’re near 2018, even 2016 wides. This makes no sense to us, as we’re not in a global crisis scenario by any stretch of the imagination.

If you look at currency levels, they’re also about 35% lower than just five years ago. And the real yield of EM debt is around a 15-year wide versus the real yield of developed market debt. Now if you look at specific countries that we like—Brazil, India, Russia, Mexico, even Indonesia as examples—the average yields there are around eight, eight-and-a-half percent. For us, that’s compelling value.

Now obviously there are risks to any emerging markets view. One risk that we’re closely monitoring is the current slowdown in China. Now this is important because any sustained slowdown there would obviously hurt global growth. China’s such a big player in the global economy, and anything that hurts that narrative wouldn’t bode well for risk assets, and obviously EM in particular. So what’s encouraging for us is the fact that China has taken some steps lately to shore up their economy and that’s really a function of the increased tariffs that have come on and hurt the manufacturing sector in China over the last year. So, more recently, Chinese officials have initiated tax cuts.

They’ve increased fiscal spending. They’ve boosted lending to the private sector. These are all positives, and ultimately this means the slowdown that we’ve seen over the past quarter, let’s say, will probably reverse over the course of the next several quarters.

Now offsetting these concerns is the fact that we do have some more clarity around the Fed and the path of rate hikes. Now historically, emerging markets will take it on the chin during a rate hiking cycle, but remember that now we’re close to the end of the current cycle, which bodes well for the asset class. It also bodes well for an investment grade and high-yield corporate bonds. These are sectors that really were impacted over the fourth quarter of last year, but they’ve also stormed back, like EM, and rightly so in our opinion.

Now we didn’t buy into the market narrative about deteriorating fundamentals or increasing defaults just because there were some select problems in names like GE—very high-profile corporates. Instead, we took the opportunity to add exposure last December, which really benefited performance as we moved into the new year. Specific areas that we like in corporate credit: short-dated callable [and] European high-yield bonds, which we think will be refinanced over the next few years. We also like European financials, which continue to strengthen their balance sheets. In our view, the current valuations right now do not reflect these fundamental improvements.