Blurred lines: the EM’ification of DM

Reflecting on 20 years of experience in rates markets – first in DM and then in EM – I’ve been really struck by the regime change that has happened in DM markets like gilts, US (2-year Treasuries) and the Japanese currency market over the last two years. Volatility in these markets has been like nothing I’ve witnessed before, and at times on a par with what I have experienced in EM. That’s what prompted this analysis and inspired the term ‘EM’ification of DM’.

To frame the analysis, I consider the typical complaints we hear about EM – them underperforming developed markets, not being worth the risk, and being a place of poor policymaking. Considering each in turn is quite revealing and points to a blurring of lines between DM and EM.

Performance

There’s no escaping the fact that the performance of certain parts of EM debt has disappointed over the past decade, at times because of weak EM fundamentals and the impact of the taper tantrum, but at times because of a relentlessly strong US dollar. This latter point draws a sharp distinction between outcomes experienced by US dollar investors and their counterparts in many other developed countries.

EM debt market performance (USD) - from 31 December 2012 to 31 December 2022

Source and date: JP Morgan and Ninety One calculations. All data in US dollars. EM corporate: JPM CEMBI. EM hard currency sovereign: JPM EMBI. EM local currency debt: GBI-EM GD. *Annualised return divided by annualised volatility using monthly return observations.

However, as the chart below shows, that dynamic has begun to shift. On a rolling annual basis, EM bonds have recently started to outperform DM again. Emerging markets have solid fundamental foundations to thank for that. As discussed in Charting a course in EM debt returns, from 2013-16, many EM economies addressed the imbalances that dragged heavily on returns during the taper tantrum (Q1 2013 to Q1 2016). And more recently, when inflation began rising, EM central banks (with a few exceptions) proved their orthodox credentials by hiking rates early and decisively. In contrast, DM central banks waited too long, and DM bond markets are now paying the price as monetary policymakers learn the same painful lessons EM central banks mastered years ago.

Rolling 1-year annualised returns – DM bonds and EM local bonds

Source: JP Morgan, Ninety One, as at July 2023. EM bonds = JPM GBI-EM unhedged, 5-7 years bucket and then DM index is the GBI Broad-weighted US, Canada, Australia, New Zealand, Germany, Japan and UK USD Unhedged 5-7 years bucket.

Volatility

Turning to the second common perception, we do not contest that EM debt is more volatile than DM – this is ultimately due to the impact of currencies and their lower average credit quality. But EM volatility remains predictably within its historic ranges. What has changed is DM volatility, which has increased significantly relative to levels seen over the past decade. EM market behaviour has remained consistent, despite the heightened risk environment that has encompassed COVID-19, war in Ukraine, energy price spikes, and the fastest Fed hiking cycle since the 1980s.

That EMs have remained relatively unscathed by these recent storms is unsurprising – they have had plenty of practice in fine-tuning their approach to handling volatility and turmoil. What is remarkable is that DM debt appears to have entered a totally new regime – one that is characterised by heightened volatility, with markets like US Treasuries, gilts and the Japanese currency market exhibiting significant volatility.

Rolling 1-year annualised volatility– DM bonds and EM local bonds

Source: JP Morgan, Ninety One, as at July 2023. Data starts in January 2004. The EM index is GBI-EM USD Unhedged 5-7 years bucket and then DM index is the GBI Broad-weighted US,Canada, Australia, New Zealand, Germany, Japan and UK USD Unhedged 5-7 years bucket.

Policymaking

As for the perceived superiority of DMs over EMs from a political and policymaking perspective, just look at the proactive moves by many EM central banks to tackle inflation, as noted above. And it’s not just in monetary policy that EM policymakers have been orthodox – many EM governments remained fiscally prudent even as inflation spurred nominal growth, resulting in primary fiscal balances being in surplus across many EM economies in 2022 and debt-to-GDP stabilising at modest levels.

Source: IMF, Moody’s, Ninety One. EMBI weighted scores across 79 EM countries.

Conclusion

EM debt is anything but a homogenous asset class. Many EM economies appear in recent times more ‘developed’ than ‘emerging’ (and vice versa), but some notable exceptions remain; selectivity and a robust active approach are still required to ensure investors are rewarded for the risk they take. But the asset class really deserves a closer – and more balanced – assessment. While DM bonds still have much to offer investors as a defensive core allocation, EM debt also deserves a place at the table. In this uncertain world of heightened volatility, it is not EM debt that has changed, it is DM.