Text on screen: What's happened in emerging markets?
Pramol Dhawan, Head of Emerging Markets Portfolio Management:The Coronavirus outbreak has hit Emerging Markets, traditionally a higher-return, higher-risk asset class, which has suffered as investors sought safe-haven assets.
Shot of a Russian building and shot of a Mexican building.
Some emerging markets, like Russia and Mexico, are also big oil exporters, so they’ve been damaged by the recent collapse in oil prices.
Shot of several oil pumps.
This has been a lot for emerging markets to take all at once. As a result, EM currencies have plunged against the dollar, whilst the premium that investors demand to hold EM assets has soared.
The shock, of course, is not an emerging market-centric one, but a global one, and we are seeing a global effort, from central banks and policymakers around the world, adding new, record amounts of monetary and fiscal stimulus to try to avert a deep and prolonged recession. Like in the US and Europe, emerging markets monetary and fiscal authorities have also injected liquidity into local markets and passed stimulus packages as they try to mitigate the shock.
Text on screen: What has been the impact?
Recent sales of emerging market bonds has been indiscriminate, impacting not only the at-risk issuers that have little policy flexibility but also higher-quality issuers with strong balance -sheets.
At one point in March, the market had become overwhelmed by one-way selling pressure – roughly $40 billion rushed out of emerging market bond markets in the span of a few weeks, which is an unprecedented number.
These dislocations have led to losses, but have also lifted the risk premiums and yields to rarely seen levels before. And this opens the door to opportunities in our view.
Chart: The chart shows how EM spreads have widened to near historic highs (top quartile): EM local yield advantage (JP Morgan GBI-EM Global Diversified Index minus generic UST 10YR), EM external spread (JP Morgan EMBI Global Index) and EM corporate spread (JP Morgan CEMBI Diversified Index).
Spreads are at near all-time wides on dollar-denominated bonds and potentially compensate investors for a level of default that has never before occurred.
Text on screen: What's next?
We believe repair will take time. EM is an “outer perimeter” asset and the system must repair itself from the inside out, first in the US Treasury market, then in the AAA-rated US mortgage market and then in the high-quality US corporate market.
Moreover, the uncertainty is still paramount and the effects of the lock-down may be longer-term than what we initially thought. Some emerging markets issuers will default – and low-quality oil-exporters are particularly vulnerable.
Therefore, over the near future, we favor dollar-denominated, high quality, emerging markets sovereign and corporate issuers, especially those with strong balance sheets. Most of the issuers operate with low leverage and excess cash reserves, which are held by central banks, sovereign wealth funds and so-called “rainy day funds”, precisely because they have navigated numerous past crises.
In emerging markets it is interesting to think about the longer-term, once the dust settles on this current episode. Local EM markets are one of the few places left that still offer “old normal” levels of yields, ranging from between 4-8% on mostly investment-grade rated bonds. This stands in sharp contrast to yields in Europe and Japan but now also in the U.S.
As volatility continues to subside, we think investors can move out of the risk spectrum towards local markets where currencies look cheap in our opinion and local yields still remain elevated compared to developed market yields.
Above everything, as ever, EM investing is all about differentiation across countries and issuers and about having a long-term view.
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