Overview of EM debt performance in Q4 2019
Emerging market (EM) local debt performed strongly in Q4 2019 with the reference index (JPM GBI EM GD) rising 5.64% during the period. Two-thirds of the gains came from EM currencies appreciating versus the USD and the remaining third from carry. Overall yields did not change over the quarter; as a result, duration did not make a significant contribution to the year-end market rally. However, EM local rates still outperformed 10-year US Treasuries, which had widened by 25 basis points (bps) over the period. The dominant story at the end of 2019 was the US-China trade conflict. The spat rumbled on through much of Q4 2019 before the two protagonists ultimately reached a trade compromise by agreeing to a “Phase One” deal. But there were reminders that the trade war was not just about the US and China. In December, Washington unexpectedly threatened to restore tariffs on steel and aluminium imports from Argentina and Brazil, although US President Donald Trump was thought to enjoy a cosy relationship with his Brazilian counterpart Jair Bolsonaro. Nevertheless, market participants decided to remain optimistic following the milestone US-China trade deal (although fragile) and deploy more risk during December.
In Q4 2019, the Nikko AM Emerging Market Local Currency Bond Strategy delivered, in absolute performance terms, 4.36% vs 4.97% for the benchmark (down in excess returns by 0.61%). Within the strategy, we implemented a structural underweight on duration in low-yielding markets (Thailand and Peru), which detracted from the performance. Additionally, our overweight duration positioning in Chile contributed negatively in November when protests in the country escalated. Lastly, we were able to recoup some performance on our long-euro proxy currencies (PLN, HUF, CZK, RON) as the EUR, boosted by widening interest rate spreads, gained over the USD.
Outlook for Q1 2020
For most of Q1 2020, speculations surrounding the coronavirus outbreak are likely to continue dominating the market and risk sentiment. Then gradually we will learn more about the virus and its impact: how fast it spreads, its mortality rate and the potential damage it could cause to the global economy. Finally, uncertainty related to the outbreak will be replaced over time by certainty.
The focus will return to these long-term macro-economic trends for 2020:
- In a world of slowing economic expansion, the EM’s relatively rapid growth is still likely to appeal to investors. While OECD economies are forecast to grow by just 1.8% in 2020, EM economies are expected to expand by roughly 4.6%.
- Headline inflation in EM countries may accelerate slightly in 2020 due to higher food prices in China. Yet central banks are likely to remain accommodative, which should provide a further boost to EM debt. EM fixed income will continue to be a natural choice for investors hunting for yield at a time when yields of many developed market sovereign bonds are negative.
- The US-China trade war remains the big unknown for 2020. Predicting what President Trump will do next is impossible, but we believe that he wants to avoid damaging the US economy in an election year. At the same time, China does not desire to see its economy lose further momentum. Therefore the trade agreement between the two economic superpowers should hold for most of 2020, in our view.
Such positive fundamentals should be very supportive for EM, especially for local debt, and will definitely help mitigate the impact of the coronavirus during most of Q1 2020. However, we expect the upside to remain limited, as the impressive performance of 2019 by EM debt looks less likely to be repeated in 2020. Indeed, gains in the low- to mid-single digits may be a more realistic outcome as lower US Treasury yields are unlikely to bolster the asset class and as sovereign spreads also look tight on a historical basis. However, after two years of underperformance, we think that EM currencies are particularly attractive and could therefore help boost the performance of local debt.