Banking sector volatility didn’t prevent emerging market (EM) debt from rising over the quarter as investors focused on the macro tailwinds from China reopening alongside relatively strong fundamentals and high starting yields across many sovereign issuers.
The sharp sell-off in EM debt in 2022 has resulted in attractive market valuations. We favour a tilt towards local currency markets, particularly across Latin America, where a slowdown in inflation coupled with expected policy easing will likely provide attractive total return opportunities.
Bond markets broadly advanced over the quarter, though with some periods of volatility, as investors adjusted interest rate expectations going forward, now suggesting many we may see rate cuts coming before the end of the year. The reopening of the Chinese economy also supported sentiment on the outlook for global economic growth, with Chinese business survey data showing early signs of improvement.
On 10 March, Silicon Valley Bank (SVB) was shut down by regulators over concerns about its solvency – marking the largest individual bank shock since the 2008 Global Financial Crisis (GFC). Signature Bank (SBNY) was wound down on 12 March, with the bank having insufficient assets to cover deposit withdrawals. The collapse of SVB powered a rally in government bonds. As at the end of March, the US yield curve steepened significantly with yields on shorter dated Treasuries falling more than those that are longer dated.
Despite turmoil in the banking sector, the US Federal Reserve (Fed) raised its benchmark interest rate by 25 basis points (bps) in March (its second hike over the quarter), bringing the federal funds rate to a range of 4.75%-5% – a level markets expect could be close to the peak in this cycle. US inflation remains elevated. The European Central Bank (ECB) raised interest rates twice during the three-month period, as inflation across the 20-member region remains sharply above the targeted level.
EM bonds posted gains in the first quarter. Strong sentiment in January arising from easing inflationary pressures and China’s exit from its zero-COVID policy moderated later in the quarter as stronger economic data in developed markets raised the prospect of tighter monetary policy. Both hard and local currency markets advanced, with local markets also benefitting from a weaker US dollar. In hard currency markets, positive returns were led by investment grade bonds, while returns for local markets were driven by Latin American issuers. The JPMorgan EMBI Global Diversified Index rose 1.9%. The JPMorgan GBI-EM Global Diversified Index advanced 5.2% in US dollar terms.
Asian issuers were among the top returning hard currency bonds in the first quarter. A rebound in economic activity in China and expectations for greater demand for goods and services, particularly tourism, served as a tailwind for the region’s emerging market issuers. Sri Lankan bonds also performed well as the country entered an IMF programme focused on debt sustainability. Malaysia, the Maldives, and Papua New Guinea also posted strong gains. African bonds lagged the broad market as several issuers had negative returns in the quarter.
Local currency bonds demonstrated broad strength, outperforming their hard currency counterparts. Latin American issuers, particularly Colombia and Mexico, led first-quarter returns as most central banks in the region slowed the pace of monetary tightening. European bonds also performed well as the region's currencies, particularly the Hungarian forint and Czech koruna, appreciated against the US dollar. Each of the Asian issuers in the JPMorgan GBI-EM Global Diversified Index had positive returns. Egyptian and Turkish bonds were notable laggards.
Past results are not a guarantee of future results.
Data as at 31 March 2023. Sources: Capital Group and JPMorgan. EM sovereign hard currency represented by JPMorgan EMBI Global Diversified Index, EM sovereign local currency by JPMorgan GBI-EM Global Diversified Index and EM corporate by JPMorgan CEMBI Broad Diversified Index. EM: emerging markets. FX: foreign exchange.
Outlook and strategy
Looking ahead, the outlook for EM debt remains cautiously constructive despite a volatile market backdrop. Global market conditions have become more uncertain as shocks across the US and European banking sectors have raised concerns that hawkish central bank policies could trigger a financial crisis. Nonetheless, EM bonds proved resilient as investors focused on their relatively strong fundamentals, high starting yields, and a potential macroeconomic tailwind from China’s reopening.
While EM local currency debt can be correlated to risk on/off sentiment, sizeable real yield differentials relative to developed markets and undervalued exchange rates should provide a buffer for any volatility. Meanwhile, the fundamental outlook for local currency debt looks positive. Despite some upside surprises earlier in the year, EM inflation looks set to decline in the first half of 2023 helped by a large drop in global food and energy prices, favourable base effects, easing global supply chain bottlenecks, softer goods demand and a rebound in EM currencies. Although the fight against inflation is not yet over (especially where inflation expectations have risen), broad disinflation should allow EM central banks to start cutting interest rates, especially given earlier and more aggressive tightening cycles than developed markets. Latin America, in particular, may see an earlier peak, thanks to a more forceful hiking cycle and higher sensitivity to declining food and energy prices. Inflation in Asia and the resulting monetary tightening has been more modest than the rest of EM and so we can expect Asian central banks to stay on hold for longer. We also believe that emerging markets currencies are well positioned to deliver positive returns relative to the US dollar due to undervalued exchange rates and the Federal Reserve’s potential pivot away from additional policy tightening later this year.
We currently see the most value in Latin American countries, such Colombia, Mexico and Brazil where interest rates have been raised early. This has helped keep inflation under control and has supported exchange rates; the Brazilian real and Mexican peso were among the few currencies that strengthened against the US dollar last year. In addition to attractive nominal and real yields, macroeconomic conditions are looking better now than late last year and the tilt towards more positive fundamentals is likely to keep overriding political risk concerns in those countries for now.
Within hard currency debt, the major emerging markets still look fundamentally strong and appear less vulnerable to any contagion from the lower-rated countries that are currently in distress. The credits that are distressed are generally issued by smaller countries with idiosyncratic and generally well understood risks. Opportunities within the dollar denominated sovereign space tend to be more idiosyncratic. High-yield US dollar sovereign bonds continue to appear broadly attractive. For many such countries, prevailing valuations suggest that their respective difficulties have already been priced in. Though valuations are less attractive across investment-grade sovereigns, we continue to find value in select lower beta credits as a counterbalance to high yield positions. Select EM corporate bonds may also provide additional diversification benefits and total return opportunities, based on healthy fundamentals and the potential for spread compression.
Data as at 31 March 2023 and attributed to Capital Group unless otherwise stated.
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