We’ve been through an extraordinary two months with a stark sell off in risk assets, but then we have also seen a sharp recovery. Can you talk about what you have observed over these last two months?

I have been in emerging markets (EM) for nearly 25 years and have seen several crises. I think that there are notable differences with this one. The first one is that for once, EM was not the epicentre of the crisis. Secondly, this began as a health scare, followed by an oil price shock, and now we’re facing more of an economic shock. It almost rapidly escalated into a financial crisis in March, but the unprecedented, fast and huge response from global central banks helped prevent this from happening. Thirdly, what distinguishes this crisis is that there will be an end to it, at some point, whether it’s through vaccines or immunity testing or something else, and we could see a recovery thereafter. With economically driven recessions, there is usually more ongoing uncertainty. 

 

EM has faced a hit to global growth, falling oil prices, local virus outbreaks and lockdowns. How have these events driven EM debt markets? Did they affect EM uniformly or did we see much differentiation? 

At the start of the crisis, the sell-off was very correlated, as was also the case with US credit and even US Treasuries. Very quickly, however, we saw differentiation between countries according to the potential impact, and we began to see an asymmetric return profile. The higher-yielding US dollar-denominated section of EM debt, and particularly those related to oil, have sold off far more than the investment grade and more diversified economies. We saw some EM credits drop around 60 points since the peak of the crisis, while some “only” dropped around 10 points, which was more in the range of US credit asset classes. The other area that was impacted was anything oil-related, so credits like Russia sold off quite sharply. There were countries that typically underperform in a crisis (because they are considered vulnerable from a funding point of view) actually holding up quite well such as Turkey. It took a while for Turkey to feel the financial and market impact of the crisis. 

We have also seen a differentiation between EM local and hard currency bond markets, reflecting the quality of issuers. Local markets tend to represent the more developed issuers with higher quality within the broader asset class. In the history of the asset classes, typically the dollar index has traded at a lower yield than the local index. They have been tracking each other for the past 12 to18 months, and now the local index is yielding significantly less (around 4.8%) than the dollar index (around 6.5%)¹ .  However, if you take the same issuers in the local currency benchmark, re-weight them for the dollar benchmark and measure their dollar market yields, they are actually lower than the same countries’ local currency bond yields.  And so, it’s not the local currency market as a whole that has held up but the higher quality, more investment grade part of the asset class. 

Even within the local currency markets, there was a marked difference between returns for local currency and dollar investors.  In local currency terms, local bonds were only down around 1% in March, whereas we saw double-digit losses for the dollar-denominated part of the asset class¹. What damaged returns for hard currency owners of the asset class was the exchange rate, which has moved a lot more, and that’s what’s expected in a crisis. 

 

Can you give us a flavour of how dysfunctional the markets have been over the past two months?

Several factors have combined to create a perfect storm in EM debt markets. The pandemic created fear and resulted in a correlated sell-off, followed by an oil price shock, which tends to impact EM as a commodity-related asset class. At the same time, passive exchange-traded funds (ETFs) were unwound in very large amounts, with demand for US Treasuries and dollars that couldn’t be met, all while banks and intermediaries were impacted by the practicalities of working from home, including that of the role of intermediation, which was impeded by regulations against risk-taking activities outside of an authorised environment. 

The good news was that the impact these issues had on market functioning was recognised very early by the US Federal Reserve (Fed), the European Central Bank (ECB) and other central banks, including within EM. Their actions allowed the system to become “unplugged”, and slowly liquidity started draining through the system, creating a two-way flow again for the market. After two to three very difficult weeks, global central banks managed to prevent a financial crisis from developing. In terms of where we are now, liquidity is still an issue, but much less than before, and we can now trade.  

1. As at 13 May 2020. Local index is the JPMorgan GBI-EM Global Diversified Index. The dollar index is JPMorgan EMBI Global Diversified. Source: Bloomberg. 

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