Returns could be lower next year but remain positive. Much will depend on the US dollar.
Lauréline Renaud-Chatelain, Fixed Income Strategist
As the end of 2019 draws near, total returns in US dollar have been good overall in the emerging-market (EM) debt space, with double-digit returns for EM sovereign debt in local currency and for EM corporate debt in US dollar (USD) alike. Underpinning this strong performance has been the impressive fall in yields and the (still) elevated coupons offered by the segment.
Three main catalysts have contributed to the fall in yields: first, central banks in most EM and developed markets (DM) have eased monetary policy; second, investors’ risk appetite has held up well, ensuring that EM debt has not suffered from contagion from volatility in individual markets like Turkey and Argentina; and finally, there has been a generally benign depreciation of EM currencies against the US dollar.
We expect total returns to be more moderate next year, in the low single digits, as we see the catalysts for this year’s strong performance fading. First, we expect less aggressive rate cuts from EM central banks as the policy rate is already quite low in many countries. Second, the low default rate coupled with improved fundamentals have contributed to pushing EM corporate spreads below 300 bps again, thereby reducing the room for further tightening.
However, we remain overweight EM sovereign bonds in local currency to play the carry (i.e. higher coupon), and we hope also to take advantage of a potentially weaker US dollar next year.
We are still neutral EM corporate bonds in US dollars, taking advantage of wider credit spreads but better fundamentals than in the DM space. Similar to DM credit, we favour quality, EM investment grade in particular, while remaining selective in high yield. A look at spread differentials suggests that EM investment grade credit is fairly valued at the moment.
We expect EM currencies to remain sensitive to (geo)political uncertainties, acting as a reminder to investors that part of the carry from EM debt can be considered as a "political premium". Hence, entering 2020, despite our expectations for a generally weaker US dollar, we cannot exclude the greenback regaining strength and acting as a safe-haven should political turmoil resurface.