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Emerging Markets
Soft landing could support emerging markets debt
Robert Burgess
Fixed Income Portfolio Manager
Harry Phinney
Fixed Income Investment Director

In 2024, numerous factors appear to be turning in favor of emerging markets (EM) debt despite the potential for weak global economic growth. A more dovish U.S. Federal Reserve (Fed) should support a rebound for EM economies. This is likely to benefit both higher-rated local currency debt — and to an extent, dollar-denominated debt — which spans a wide variety of economies and markets, extending all the way to the riskier and smaller economies often referred to as the frontier markets.


We see the largest opportunities within core (higher rated) local currency sovereign debt, along with select investment-grade (rated BBB/Baa and above) and high-yield dollar-denominated sovereign issuers. If incoming inflation data permits the Fed to cut rates, it should allow the central banks in EM countries to move in a direction that better reflects their domestic outlooks. Dollar-denominated issuers may also benefit from potentially lower funding costs. In most of the core economies, inflation is expected to decline throughout 2024. Falling interest rates should be positive for duration, especially for local currency debt holders. 


While EM currencies recovered in 2023, the strength of the U.S. dollar could still pose a challenge, even though the dollar looks overvalued on most fundamental metrics. This could change with lower U.S. rates, although the process of unwinding dollar strength is likely to be gradual given the real rate level is still supportive of the dollar over other major currencies, and growth outside the U.S. remains relatively weak. Elections in several EM countries could also disrupt the status quo.


The table below shows how EM currencies and debt have performed before and after the Fed began cutting rates in previous cycles. Both local and hard currency (dollar-denominated) bonds have rallied the most prior to earlier rate cuts, while EM currencies have performed better after the rate cuts began.


How EMs performed in previous Fed rate-cutting cycles

Chart shows how emerging markets currencies and debt have performed before and after the Fed began cutting rates in previous cycles. Both local and hard currency (dollar-denominated) bonds have rallied the most in the run up to prior rate cuts, while EM currencies have performed better after the rate cuts. On average, EM currencies have gained 2% against the dollar in the year prior to the Fed’s first rate cut, 1% in the six months prior, 1% in the six months after the first cut and 7% against the dollar in the first year following the Fed’s first rate cut in a cycle. Over those same periods, on average, hard currency debt has gained 11%, 6%, 5% and 4%, respectively, and local currency debt has gained 14%, 6%, 6% and 3%, respectively. In the first year prior, six months prior, six months post and one year post the cutting cycle beginning July 2019, EM currencies gained 2%, 2%, 3% and 9%, respectively. Over those same periods, hard currency debt gained 11%, 9%, 4% and 3%, respectively and local currency debt gained 8%, 4%, 2% and lost 1%. In the first year prior, six months prior, six months post and one year post the cutting cycle beginning July 2007, EM currencies lost 7%, 4%, 5% and gained 2%. Over those same periods, hard currency debt gained 7%, 1%, 4% and 0% and local currency debt gained 21%, 8%, 11% and 7%. In the first year prior, six months prior, six months post and one year post the cutting cycle beginning January 2001, EM currencies gained 10%, 5%, 7% and 9% respectively. Over those same periods, hard currency debt gained 14%, 7%, 6% and 10%; data on local currency debt is not available for this cycle.

Sources: Bloomberg, J.P. Morgan. Past results are not a guarantee of future results. Hard currency debt represented by J.P. Morgan Emerging Markets Bond Index — Global Diversified (EMBI). Local currency debt represented by J.P. Morgan Government Bond Index — Emerging Markets Global Diversified (GBI-EM GD). EM currencies represented by EM currencies weighted by GBI-EM GD versus the U.S. dollar. Exact dates are as follows: January 3, 2001; September 18, 2007; and July 31, 2019. Returns in USD.

The U.S. may escape recession, even if global growth remains weak


EM assets have historically been highly correlated with U.S. economic growth. The U.S. economy looks poised to maintain an economic growth rate above 2%, even as it contends with the lagged effects of tightening financial conditions. Labor markets remain robust, although rising consumer debt has caused some concerns. 


EM debt spreads during U.S. rate cycles and recessions 

Chart shows J.P. Morgan Emerging Markets Bond Index (EMBI) spreads and the federal funds rate from 2000 to 2023. In prior cycles, EMBI spreads have tended to rise as the Fed initially began cutting rates and to fall as the federal funds rate stabilized. Since the federal funds rate began rising in 2022, EMBI spreads have hovered in a range from around 350 basis points (bps) to 460 bps. Chart also shows periods of recession as determined by the National Bureau of Economic Research in 2001, 2007-2008 and 2020.

Sources: Bloomberg, J.P. Morgan. As of November 30, 2023. Past results are not a guarantee of future results. Left vertical axis: J.P. Morgan Emerging Markets Bond Index (EMBI) spreads (bps). Right vertical axis: federal funds rate (%). Shaded periods are U.S. recessions as determined by the National Bureau of Economic Research.

Outside of the U.S., growth is expected to remain relatively weak. Compared to the U.S., Europe was hit more heavily by the energy shock, and the region still faces some of the most difficult policy challenges with the tradeoff between inflation and growth. Eurozone economic activity has stabilized at subdued levels, and there remains a significant risk of contraction in some economies. However, we could experience a recovery in the second half of 2024, if increased investment in areas like the energy transition and defense picks up, inflation comes down and consumers start to see the benefits of stronger real income growth.


China is likely to have to adjust to a decelerating growth rate in the coming years. Elsewhere in the emerging markets, we expect continued economic expansion in Asia (outside of China), a deceleration in Latin America and broadly stable growth in Europe, the Middle East and Africa. 


Core emerging markets bonds may benefit from declining rates


If monetary policy loosens in major developed markets, a decline in interest rates could work in favor of local currency EM bonds. While EM countries have traditionally struggled with inflation, more developed EM central banks have raised interest rates earlier and more aggressively than the developed world to prevent people’s inflation expectations from accelerating.


Inflation now looks ready to return to central bank comfort zones for most EM countries by the end of 2024. As a result, a long duration position looks attractive in many Latin American markets, including Brazil and Mexico. Long duration positioning also looks compelling in South Africa, whose real rates are near the upper end of historical ranges and have more room to decline than U.S. Treasuries.


Interest rates expected to come down in EM

Chart shows market expectations for policy rates in China, India, Poland, Mexico, Brazil, the Czech Republic and Chile. Over the next year, India is expected to cut policy rates by 49 basis points (bps), Poland by 52 bps, Brazil by 158 bps, Mexico by 176 bps, Chile by 297 bps, Czech Republic by 316 bps and Hungary by 417 bps. China is expected to raise policy rates by 9 bps.

Source: Bloomberg. As of February 16, 2024. 

Central banks in Asia are likely to cut rates later than the rest of the EM world. Asian local currency debt tends to be more correlated with global markets, but duration opportunities still exist. In China, low yields seem justified by stubbornly low inflation and growth challenges.


Caution is still warranted in Central Europe. Inflation does seem to have rolled over (although it appears unlikely to return to target as projected), and growth has been sluggish. However, those trends are reflected in local yields, with aggressive easing cycles priced into bonds.


Across hard currency debt, spreads are fairly tight within the core investment-grade EM economies. But compared to U.S. investment-grade corporate bonds, spreads look reasonably attractive, thus presenting some relative value opportunities. Absolute yield levels also remain reasonably high. Part of the appeal of these holdings is that they provide diversification benefits to portfolios. South Korea and Mexico are examples of some higher rated credits in which we have conviction.


Some corporate dollar issuers may also present value. Fundamentals within EM corporates look solid as most EM corporate treasurers have taken a prudent approach to borrowing. The geographic representation and risk structure of EM corporates is quite different from sovereigns, and thus provides an element of diversification.


Frontier markets face greater challenges


The Fed’s pivot should reduce external financing pressures on frontier markets, but they will likely continue to face headwinds from relatively weak global growth, persistent dollar strength and higher U.S. rates than in the prior two decades (even with a more dovish Fed). Spreads on most of these credits are still relatively wide, offering a significant valuation cushion in many cases. However, selectivity is key. 


EM debt spreads by rating group

This graph provides a visual representation of how the debt spreads of emerging markets have changed over time, segmented by different rating groups. The spikes and fluctuations in the lines can give insights into the economic conditions and creditworthiness of these markets during the represented years. Chart shows a line graph that displays the J.P. Morgan EMBI (Emerging Market Bond Index) spreads, measured in basis points (bps), over the years from 2005 to 2023. The graph represents three different rating groups: BBB/BB, AA/A, and B/C. The BBB/BB rating group (dark blue line) remains relatively stable throughout the years, with minor fluctuations. The AA/A rating group (light blue line) shows significant spikes around the year 2009 and between the years 2021-2023, but is otherwise stable. The B/C rating group (green line) exhibits the most volatility, with sharp increases in 2009, 2020 and from 2021 onwards. The y-axis of the graph ranges from 0 to 2,000 basis points. All three lines show a significant spike around 2009, during the global financial crisis.

Source: J.P. Morgan Emerging Markets Bond Index (EMBI). As of December 1, 2023.

Attractive opportunities, but some risks to consider


Over half the world’s population will be asked to go to the polls in 2024. In addition to parts of the developed world, this includes many core EM countries, such as India, South Africa, Indonesia and Mexico, as well as a number of countries that are potentially heading toward or already in the midst of debt restructuring, such as Sri Lanka, Ukraine and Ghana. With so many economies heading into an election year, volatility could potentially increase, so diversification will be key for investors. Likewise, geopolitical risks remain elevated and warrant careful monitoring.


Overall, developing economies have proven to be resilient in recent years, and we believe emerging markets debt will remain compelling for investors if fundamentals and starting yields continue to look broadly attractive. These markets were thoroughly tested in 2023 and came out stronger for it. In addition to the aggressive U.S. rate-hiking cycle, emerging markets also had to contend with wars, U.S. banking stress in March and a sharp bond selloff. The fact that the more developed EMs were able to weather this volatility without significant impact demonstrates the progress these economies have made. 



Robert Burgess is a fixed income portfolio manager at Capital Group with 32 years of investment industry experience (as of 12/31/2023). He holds a master’s degree in economics from the University of London and a bachelor’s degree in politics and economics from Oxford University.

Harry Phinney is a fixed income investment director with 18 years of industry experience (as of 12/31/23). He holds an MBA in international business from Northeastern University, a master’s degree in applied statistics and financial mathematics from Columbia University and a bachelor’s degree in international political economy from Northeastern University. 


The value of fixed income securities may be affected by changing interest rates and changes in credit ratings of the securities.

 

The J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified is a uniquely weighted emerging markets debt benchmark that tracks total returns for U.S. dollar-denominated bonds issued by emerging markets sovereign and quasi-sovereign entities. This index is unmanaged, and its results include reinvested dividends and/or distributions but do not reflect the effect of account fees, expenses or U.S. federal income taxes.

 

J.P. Morgan Government Bond Index – Emerging Markets Global Diversified covers the universe of regularly traded liquid fixed-rate domestic currency emerging market government bonds to which international investors can gain exposure. This index is unmanaged, and its results include reinvested dividends and/or distributions but do not reflect the effect of account fees, expenses or U.S. federal income taxes.

 

BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg or Bloomberg’s licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg’s licensors approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

 

Credit rating – Typically ranging from AAA/Aaa (highest) to D (lowest), these are assigned by credit rating agencies such as Standard & Poor’s, Moody’s and/or Fitch as an indication of an issuer’s creditworthiness.

 

Credit spread – A credit spread is the difference in yield (the expected return on an investment over a particular period of time) between a government bond and another debt security of the same maturity but different credit quality.

 

Duration measures a bond’s sensitivity to changes in interest rates. Generally, a bond's price will go up 1% for every year of duration if interest rates fall by 1% or will go down 1% for every year of duration if interest rates rise by 1%.

 

Frontier market – Countries with investable stock markets that are less established than those in the emerging markets.

 

Hard currency – Refers to money issued by a nation that is seen as politically and economically stable. Hard currencies are widely accepted around the world as a form of payment for goods and services and may be preferred over the domestic (local) currency.

 

Inflation – The rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market – in other words, too much money chasing too few goods. Core inflation metrics strip out volatile items like food and energy.

 

Issuer – A legal entity that develops, registers and sells securities to finance its operations. Issuers may be corporations, investment trusts, or governments.

 

Policy rate – An interest rate set by a central bank to implement its monetary policy.

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