Hidden GEMs: Don’t dismiss EM debt

A disappointing decade in some areas of the asset class has left asset allocators questioning the investment case for EM debt. Grant Webster, Co-Head of Emerging Market Sovereign & FX, provides an analysis of two contrasting decades and suggests that asset allocators should not dismiss the asset class.

7 Aug 2023

07 August, 2023. While emerging market (EM) fixed income has proven its worth in long-term investors’ portfolios over the past 20 years – delivering outcomes comparable to those from developed markets (DM) – behind this lie two starkly different decades. Between 2003 and 2013, EMs materially outperformed to deliver compelling returns. This caught the attention of asset allocators, many of whom then entered the EM debt asset class with lofty return expectations, attracted by high revenue growth and resilient margins seen among quality companies in countries that were quickly building wealth. But over the subsequent decade (2013-2023) parts of the asset class have generated lacklustre returns. This has left some investors questioning the role of EM beta in portfolios.

In each of the past two decades, the US dollar has been a dominant driver of EM local currency debt returns. Between 2003 and 2013, the US dollar weakened by over 20% relative to EMFX, providing a boost to EM local debt returns. On the flipside, the most recent decade has seen the US dollar strengthen by almost 30%, weighing heavily on EMFX and the overall returns delivered by the EM local currency bond investable universe. Weakness in EM spot rates against the strong dollar took a particularly heavy toll during the taper tantrum years (2013-16) and then again in the COVID crisis (2020).

While US dollar strength played an outsized role in EM (local currency) debt performance over the past decade, it’s also important to acknowledge the role of economic vulnerabilities within EM. These developed in the five years post the GFC, coming centre stage in the taper-tantrum period. Large current account deficits financed by loose global liquidity, together with hot portfolio flows and weaker fiscal balances, also contributed weakness in EM debt in those subsequent years. Crucially, though, this precipitated a significant rebalancing of EM economies, laying a foundation of resilience, as we explore more below.

If we decompose asset class returns over the past two decades, we see that income has been the primary long-term driver. This is one of the reasons we are optimistic over the outlook.

Income as primary return driver

Local currency EM debt

First Decade
(2003-2013: 120 months)
Second Decade
(2013-2023: 120 months)
Full period
(2003-2023: 245 months)
a Bond Yield 3.3% 2.2% 2.8%
b EM Bond Capital 2.2% -0.8% 0.7%
c = a + b Bond return 5.5% 1.4% 3.6%
d EM FX Yield 3.3% 3.6% 3.4%
e EM FX Spot Return -0.2% -3.3% -1.8%
f = d + e EM FX before dollar 3.1% 0.2% 1.6%
g US Dollar Spot Return 1.3% -2.1% -0.1%
h = f + g EMFX Return 4.5% -1.9% 1.4%
I = c + h TOTAL 10.3% -0.6% 5.1%

Hard currency EM debt

First Decade
(2003-2013: 120 months)
Second Decade
(2013-2023: 120 months)
Full period
(2003-2023: 245 months)
a UST yield 3.5% 1.9% 2.7%
b UST capital  0.5% -1.1% -0.3%
c = a + b Duration Return 4.1% 0.7% 2.4% 
d Spread yield 3.4% 3.7% 3.6% 
e Spread change  0.9% -1.6% -0.4%
f = d + e Credit Return 4.3% 2.1% 3.2%
g = c + f TOTAL 8.6% 2.8% 5.7%

Source: Bloomberg, June 2023. For illustrative purposes only. JP Morgan indices shown – EMBI and GBI-EM.

Here are the three key considerations we think matter for investors assessing the prospects for the asset class.

First, EM Fundamentals are improving and – based on our measures of credit vulnerability – are at the strongest levels since 2014. Fiscal strength is seeing the biggest improvement, with increasingly healthy primary fiscal balances across EM. Funding strength is better than the pre-2012 period given growth in local funding markets, and external resilience is improving post-COVID on stronger basic balances (current account + FDI). While headline economic growth is being weighed down by growth and inflation volatility, the structural growth premium of EM above DM remains intact and above its long-term average, even though it is not back at the very high levels seen in the first decade we consider in this report. All of this points to EMs being in a good position structurally.

Secondly, looking across a suite of valuation metrics, the dollar looks over-valued. Although it has moved off its recent highs, it remains at levels last seen in the early 2000s. While we are not advocating for a significant sell-off in the US dollar – or, conversely, an EMFX bull run – this headwind to EM local currency bonds looks less challenging than over the prior decade, making it likely that compelling carry can resume its role as key driver of returns.

Finally, turning to valuations, the spread pickup relative to DM remains appealing. While spreads are below historical highs this is expected, given the relative resilience of EM fundamentals. The recent rise in EMBI yields looks not dissimilar to the 2008-2009 experience, while many local currency yields are still close to post-GFC highs. Given yields have historically been a reliable indicator of forward-looking returns, current valuations support the case for EM debt, particularly in light of the stronger EM fundamentals currently witnessed.

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