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The challenges and opportunities for EM bonds in 2019

Kris Xippolitos

By Kris Xippolitos

Head - Fixed Income Strategy

December 4, 2018Posted InInvestments, Fixed Income and Investment Strategy

As we look to the coming year, valuations in global emerging markets look much different than 12 months ago. While we would not classify EM bonds as overly cheap, spreads and yields have largely discounted many known risks. Still, elevated volatility should be expected and will likely remain a challenge to benchmark performance over the coming year.

Some challenges include:

  • US Federal Reserve policy tightening: We expect 100bp of rate hikes through 2019 (including December), as long as financial conditions allow. Markets are discounting only half that, which increases the risk of rate shocks.
  • US/China trade war: Though a tentative agreement between President Trump and President Xi have temporarily placated markets, political volatility is hard to predict. Therefore, we believe it’s fair to expect uncertainty over trade to persist. The larger EM concern would be any significant negative impact to China growth, despite the likelihood for an offsetting policy response by the Chinese government.
  • Oil prices: Crude oil prices could be a consistent headwind for EM assets in 2019. Especially for net oil exporters, particular in Latin America and the Middle East. Of course, other countries reliant on importing oil can benefit from lower oil prices, such as China and India.
  • Political risks: Argentina, India, Indonesia and South Africa all have major elections in 2019. As we’ve learned from past elections, market volatility tends to rise in the weeks before (or sometimes after). Of course, outcomes can also eventually change investor sentiment, as the case in both Brazil and Mexico.

Our outlook on external EM spreads will be largely contingent on the outcomes of the above risks. However, there are other positive signals to consider. Firstly, the US growth outlook may be slowing, but leading indicators suggests the aging expansion should continue. This should keep the Fed from altering their historically slow tightening cycle. Secondly, previous China policy easing is beginning to have a positive impact on their growth cycle, while further stimulus is expected. Thirdly, positive earnings growth and cheaper valuations favors a rebound in equities. As such, improvements in risk appetites may fuel flows back into EM markets.

That said, we believe EM debt is poised to modestly outperform over the coming year. Even if sovereign EM spreads end 2019 unchanged, this would imply an expected total return between 3-4%. While low single digit returns may be unappealing, consider that this may come in an environment where global aggregate fixed income benchmarks struggle to produce positive returns.

As such, we continue to hold a slight overweight in EM debt in our global asset allocation framework (both external and local debt).