2013 has been challenging for Emerging Market Debt (EMD). After a solid 2012 in which the EMBI Global Diversified Index provided an 18% return, investors reacted to slowing economic growth and concerns about U.S. monetary policy by reducing exposure to the asset class, which declined by 8.5% in the first half of the year. What does near-term volatility imply for the rest of the year and beyond? Is it an opportunity, a warning sign, or something in between?
In the near term, our perspective is cautious. EMD has hit an inflection point of market adjustments to the potential “beginning of the end” of ultra-easy global monetary conditions. Higher rates imply a rotation away from more volatile fixed income areas and into more traditional market segments. However, despite recent noise to the contrary, EM economies are generally improving and the financing needs of sovereign and corporate issuers are relatively moderate—potentially limiting supply and supporting credit fundamentals and spreads.
Just as important are the discounts in emerging markets (EM) vs. developed market (DM) counterparts, reflecting less the realities of credit and interest rate concerns and more the overall market inefficiencies and a yield premium associated with perceived risk.
We believe that investors have made too much of slowing growth in emerging markets. We expect some economic resurgence, supported by global recovery, particularly in the developed markets, which should partially offset China's slowdown, even as EM policymakers gradually scale back monetary support.
In terms of individual segments:
-We believe that Sovereign credit spreads are attractive relative to historical levels and current default rates. Low/medium spread names have moved to what we consider compelling levels, although higher yield and frontier issues seem more risky from a valuation perspective.
-Corporates, meanwhile, should largely mirror Sovereign performance, but carry some risk due to recent outperformance vs. Sovereigns. Among Corporates, high yield issues offer an additional spread cushion in the event of a U.S. Treasury sell-off.
-Local Currency debt is our preferred market segment through year-end 2013. EM central banks are mostly neutral to accommodative, which should limit risk from U.S. interest rates. While below-potential growth is likely to be beneficial for EM local bonds, monetary shifts between EM and the U.S. and commodity weakness may hamper the currencies in which such debt has been issued.
These views reflect our base forecast. If economic growth proves stronger than we anticipate, EMD spreads are likely to narrow on improving credit fundamentals but to some degree should be offset by higher Treasury yields, particularly for Sovereigns. A slower growth scenario would likely provide stronger total returns for all three segments (especially Sovereigns) given implications for U.S. Treasuries. A renewed global slowdown is our least likely scenario and would be negative across the board.
Overall, EMD's recent underperformance compared to U.S. spread strategies and European peripheral sovereigns have improved the relative value of EMD. While the next several months may see tactical outflows due to U.S. rate increases, we anticipate that full year flows will remain positive, at roughly $40-50 billion. Moreover, EMD should continue to benefit from the long-term trend of inflows, as fixed income investors add exposure to emerging markets, which are structurally underrepresented in their portfolios.
Moderate second-half economic gains
In our view, ongoing normalization of economic conditions in developed markets will remain a key driver for EMD for the remainder of 2013. With the scenario of improving U.S. growth dominating investor perceptions, Federal Reserve policy will likely prove highly influential to EM results, as was demonstrated in the setbacks after the Fed's references to “tapering” its QE-related asset purchases. Our base case is that the Fed will reduce such purchases later in 2013. As such, U.S. Treasury yields should trend somewhat higher and could become more volatile as investors begin to price in more recovery and lessen their fixed income purchases.
Although emerging markets have shown economic resilience since the 2008-2009 financial crisis, overall results have been affected by European weakness, the subpar expansion in the U.S., and periodic anxiety about China's efforts to avoid property speculation and develop a more balanced economy. The crisis has also introduced new challenges for policymakers, in that the “new normal” in the DM, translating into lower consumption, has made the export-orientated EM growth model less viable. This is pushing emerging markets to rebalance their economies in favor of domestic consumption and away from heavy investment, resulting in tougher times for commodity exporters.
Following overall EM growth of 5.2% in 2012 and 4.8% in the first half of 2013, we believe EM growth is likely to accelerate modestly to achieve 5.3% for the full year, and reach 6.1% in 2014. This would be aided by the global recovery, stronger second-half growth in China and continued support from EM policymakers.
China is obviously a key factor in EM economic health. Recent softening there has contributed to weaker commodity prices, which has impacted producing countries broadly. Even with current challenges, however, we believe China could grow by 7.6% this year, with the new government settling in, social financing growth filtering into investments and increased real estate investment on rising property sales. The new, cooler rate is supportive for Asian and other EMD markets.
Overall, growth in EM Asia should pick up by 10 basis points to 6.5% this year and further to 6.7% in 2014, with the more advanced Asian economies of Korea, Taiwan, Hong Kong and Singapore moving to catch up to the ASEAN-4 (Indonesia, Malaysia, Philippines and Thailand), thanks to a continued recovery in exports to the U.S. We have increased our GDP growth forecasts in India by 60 basis points to 6.3% for 2013 and expect 7.2% for 2014, looking past current tightening in India, which we deem as temporary. Inflation remains tame but the combination of very accommodative monetary policy and strong domestic demand growth in the ASEAN-4 may drive inflation higher.
We believe Japan's monetary shift is a positive for EM Asia. Japan's recently introduced program to reflate the economy will likely impact the region in two ways: First, the country is now more competitive with EM Asian markets. Second, a rise in Japan's domestic demand could increase imports from other Asian countries.
The expansion in EM Europe should remain on track at 2.2% in 2013 and rise to 3.1% next year. We expect the unwinding of last year's stresses in the eurozone, as well as the lowering of interest rates by several central banks, to support growth.
Growth in the Middle East should soften due to flattening crude oil production by the Gulf Cooperation Council member states. Growth in Africa should remain at 4.1% this year as post-Arab spring challenges and weak commodity prices hold back many economies, but should then accelerate to 4.9% in 2014.
As for Latin America, we believe the slight uptick in expansion there should be driven by the recovery in Brazil (from 0.9% last year to an expected 2% in 2013), while Mexico is likely to slow from 3.9% to 2.8%. Fiscal challenges are increasing rapidly in Venezuela and Argentina, as the authorities have elevated public spending ahead of elections in April and October of this year, respectively.
The global fixed income universe, including emerging markets, continues to see near-historic low yields, reinforcing the appeal of taking an opportunistic approach to broaden potential sources of yield and total return. We believe the structural case for EMD remains strong, as investors increasingly recognize the economic significance, improved credit quality, and depth of EM economies and markets. Although improved global growth could provide a near-term headwind of higher Treasury rates, we believe that slow, steady economic improvement could provide a modestly positive backdrop for EMD, particularly in comparison to other sectors within fixed income.
Rob Drijkoningen and Gorky Urquieta and co-heads of the emerging-markets debt team at Neuberger Berman Group LLC.