Overview of EM debt performance in Q1 2020

Emerging market (EM) local debt performance was sharply negative in Q1 with the reference index (JPM GBI EM GD) falling 15.21% during the period. This was mainly due to weak FX performance as the alarming spread of the novel coronavirus (COVID-19) led to a deterioration in investor sentiment from late February onwards, with a particularly sharp deterioration in March which led many investors to flock to safe haven assets. Local bond performance was also marginally negative due to a combination of additional fiscal stimulus, contagion from weaker FX rates and above all, poor liquidity conditions amid a number of large redemptions.

Oil-related currencies including the Russian rouble and the Mexican and Colombian pesos were hit particularly hard. This followed a major decline in the price of oil, triggered by the Saudi Arabia-led price war against Russia, seemingly in retaliation for the latter failing to agree to an increase in the previously agreed sharing of oil production cuts. This resulted in crude oil prices collapsing nearly 50% during the month of March. For Mexico, this is specifically likely to strain government finances via the significant funding needs of the state owned oil company, Pemex, despite having partially hedged this year’s expected oil revenues.

Outlook for Q2 2020

The most prevalent risk to emerging markets right now remains the alarming spread of the novel coronavirus. There is much uncertainty regarding the extent and severity of the outbreak, but we are already seeing a strong global policy response. And while there will inevitably be a significant near-term growth impact, we expect this to be relatively short-lived.

Speculation around the virus outbreak is likely to continue dominating market and risk sentiment in the coming weeks and months. Then, little by little, we will learn more about the speed at which the virus spreads, the level of mortality, sensitivity to higher temperatures, potential treatments and possible vaccines and critically, the potential damage to the global economy. Ultimately, uncertainty related to this topic will, in time, be replaced by certainty. When such a time comes, we foresee the following long-term macro-economic trends driving EM again:

  • In a world of slowing economic expansion, emerging markets’ relatively higher growth is still likely to appeal to investors. The IMF now forecasts advanced economies contracting by 6% in 2020, and emerging markets are also likely to shrink, but at a much lesser pace of1%. Given the temporary nature of the economic shock, a relatively rapid rebound is expected next year, with emerging economies forecast to outpace their developed counterparts once again with growth at 6.6% versus 4.5%, respectively.
  • Despite the initial risk of higher cost push inflation pressures from weaker FX rates, we expect the threat of significantly weaker demand in the coming months to be the dominant driver for many central banks. Hence, emerging market central banks are likely to remain in accommodative mode, supported by the highly accommodative policies being enacted by developed market central banks, which should provide a further boost to the asset class. We therefore continue to express a preference for countries with scope to cut rates further, namely those with high real yields, whilst avoiding those which have exhausted their monetary easing capacity.
  • Finally, we note that after several years of underperformance, EM currency valuations are particularly attractive and could therefore help boost the performance of local debt once we transition to the recovery stage of the epidemic and risk appetite duly recovers.

We believe that emerging fixed income will continue to be a natural choice for investors hunting for yield at a time when many developed market government bonds are offering negative yields. Yet we also believe it is critical to avoid taking undue risk, particularly when external conditions turn less favourable. With this in mind we believe that our investment strategy of combining our proprietary top-down asset allocation approach with a detailed, country-level assessment will be the best approach to deliver attractive returns to emerging markets investors in the coming years.