At the start of 2021, we are cautiously optimistic on the outlook for emerging market bonds. Two key positives for the asset class are an expected strong rebound in global economic growth and a more predictable US presidency. However, prices have already rebounded significantly in anticipation and there are some important risks for the outlook. As such, we think a selective approach will be more important than ever.
On the economic front, a very strong recovery is anticipated, with the IMF forecasting emerging market growth of +6% from an estimated contraction of -3.3% in 2020. A key driver of this will be broader global economic normalisation, helped by increasing vaccine dissemination. The economic outlook for China is particularly important for emerging markets because it is such a huge source of demand, not least for commodities. Given this, expected Chinese economic growth of around +8% in 2021, from an estimated contraction of -2.0% in 2020, is a key positive.
When growth picks up, inflation usually rises too, which normally tends to push central banks to raise interest rates. However, current conditions are far from normal. Even before Covid-19 struck, inflation across the world had been unusually low for a long time. With the pandemic severely hitting global demand, many countries are experiencing negative prices or ‘deflation’. This suggests that interest rates aren’t likely to be raised by much, if at all, from current historically low levels. Along with continuing support from government spending, this certainly entails a helpful backdrop for emerging market bonds.
While interest rates are extremely low globally, emerging market bonds still offer among the best yields available. For example, 10-year government bond yields of +6% and +5% in Indonesia and Mexico respectively are multiples of the current +1% 10-year US treasury yield. Of course, the large difference is for a reason, but the key point is that the size of the gap should continue supporting demand for emerging market bonds. This will apply particularly to ‘yield-hungry’ income-focused global investors.
Emerging market bond yields versus US treasury yields
Source: JP Morgan, data as of end-December 2020
One other quite important development is the recent change of US leadership. Under President Biden, US foreign policy will be more familiar and more predictable. The return to ’normality’ will be most noticeable in trade policy. Although trade tensions certainly won’t disappear, our base case is that the new Biden administration will use tariffs less frequently. This is positive for export-intensive emerging markets, especially China and nearby countries deeply integrated into its productive supply chain.
However, while the overall backdrop may be good, the key question for investors is – how much of this is reflected in prices? The short answer is: probably quite a bit. Following the peak period of pandemic fear in late March 2020, we have seen a sustained recovery in emerging market bonds. This has made the overall valuation story somewhat less compelling.
Beyond valuation vigilance, investors also need to be cognisant of the key risks for the outlook. In this regard, the biggest worry for the global economy is a slower than expected recovery from the pandemic. For example, vaccine dissemination could be slow, meaning a slower return to economic normality. A weaker-than-expected Chinese economic recovery would also be unhelpful. Other key risks include rising US treasury yields and/or a sustained US dollar strength. Either of these would tend to make emerging market assets look relatively less attractive for global investors.
As such, we think the current environment calls for greater selectivity. In terms of segments, the areas which still seem relatively ‘cheap’ are higher yielding sovereign government bonds and local currency bonds. Emerging market High Yield sovereign bonds (also known as frontier markets) have lagged the compression in US High Yield bond spreads for some time. Moreover, this lag was accentuated in the past year, further expanding the spread between the two markets.
In terms of local currency emerging market bonds, an environment of sustained US dollar strength has been a key driver of underperformance over the past decade. This certainly makes the asset class look cheap on a relative basis. Furthermore, if increased US government spending leads to a weaker dollar as widely expected, this would be especially welcome for this asset class.
Finally, another relatively attractive segment is emerging market corporate bonds. Here, in marked contrast to developed countries, companies have spent much of the past decade reducing their debt levels. This has improved their credit position and reduces the likelihood of them not being able to pay their debts.