CONTRIBUTORS
Kevin J. Ritter, CFA
Robert O. Abad
At Western Asset, we’ve been steadfast in our view that emerging markets (EM) would benefit from a backdrop of subdued growth and inflation in the US, and a generally benign global economic environment. During the initial seven months of the year, EM assets performed well as investors discounted the likelihood of a US recession. However, more recently, EM market sentiment has taken a turn for the worse as investors have begun to consider the possibility of stronger US growth compared to the rest of the world and a prolonged period of higher interest rates. This concern, combined with uncertainties about the ability of the US to manage its high deficit and debt burdens under such conditions, led to a spike in US Treasury (UST) yields. This, in turn, disrupted the expected monetary easing cycle in Brazil and Chile and delayed the first rate cut in Mexico. Indonesia and the Philippines also raised interest rates preemptively to support their currencies. In short, the notion of US exceptionalism significantly affected EM valuations (Exhibit 1).
Exhibit 1: EM Valuations—A Tale of Two Expectations
Sources: Bloomberg, Western Asset. As of October 31, 2023. The above figures are in percent (%) terms. Agg is represented by the Bloomberg US Aggregate Index; US Credit is represented by the Bloomberg US Credit Index; US HY is represented by the Bloomberg US Corporate High Yield Index; EMBIG Div (USD) is represented by the J.P. Morgan EMBI Global Diversified Index (EMBIGD); EM Frontier (USD) is represented by the J.P. Morgan Next Generation EM Index; GBI-EM (local) is represented by the JPMorgan Government Bond Index-Emerging Markets (GBI-EM). Past performance is not an indicator or a guarantee of future results. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
EM valuations—A tale of two expectations
In the past week, the US Treasury’s announcement of a reduction in the supply of longer-dated USTs and weaker-than-expected US labor and manufacturing data have reinforced two of our key takeaways:
- A likelihood of a soft-landing scenario in the US has now increased, which should ease the extreme upward pressure on UST yields and create a more favorable environment for EM. Historically, US recessions have typically delivered a one-two punch of slower growth and capital flight for a number of EM countries. When confronted with these difficult situations, EM policymakers found themselves compelled to tighten monetary and fiscal policies rather than implementing counter-cyclical measures to offset the impact of external economic shocks. This approach, especially for the more fragile EM countries, further constrained policymakers’ ability to effectively manage the dual challenges of mounting debt-servicing costs and exchange-rate pressures leading to deteriorating sovereign credit metrics, a surge in sovereign spreads and limited access to external capital markets (Exhibit 2).
Exhibit 2: US Recessions Have Weighed Heavily on EM Performance
Sources: JPMorgan, Federal Reserve Bank of New York. As of September 30, 2023. EMBI is represented by the J.P. Morgan Emerging Market Bond Index. Frontier is represented by the J.P. Morgan Next Generation EM Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
- Recent statements from Federal Reserve (Fed) Chair Jerome Powell and other Fed governors, signaling a more restrained approach to monetary policy due to the observable slowdown in US growth and inflation, strengthen our conviction that the Fed is now on hold; this is highly supportive for EM local markets. It’s important to highlight that EM local markets have historically exhibited strong performance in the months following the conclusion of Fed tightening cycles.
Exhibit 3: Historical Sensitivity of EM Rates to the Peak US Rates
Source: JPMorgan. Note: Changes (basis points) in 10-year rates for different countries in the six months following the respective peaks in 10-year USTs close to the end of the Fed tightening cycles. Dates indicate the month of the peak in UST 10-year rates. As of October 31, 2023.
While we have consistently maintained a constructive outlook for EM, we remain vigilant, recognizing the potential for unanticipated events and fears that can suddenly grip broader market sentiment. For instance, in the upcoming months, market participants will be closely monitoring political developments, starting with presidential elections in Argentina later this month, followed by 14 other pivotal elections. That stated, we see US macro conditions and interest-rate dynamics aligning with our expectations and a Fed that appears to be adopting a more cautious stance on policy tightening. We believe all of these factors lead us to the conclusion that EM, particularly local market debt, is now well-positioned, “primed and ready.”
Definitions:
Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.
Frontier nations are countries with investable stock markets that are less established than those in the emerging markets.
The Bloomberg US Aggregate Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.
The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market.
The Bloomberg US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government-related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes non-US agencies, sovereigns, supranationals and local authorities.
The J.P. Morgan EMBI Global Diversified Index (EMBIGD) tracks liquid, US Dollar emerging market fixed and floating-rate debt instruments issued by sovereign and quasi-sovereign entities.
The J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) tracks local currency bonds issued by emerging markets. Weightings among countries are more evenly distributed within the index than in the global diversified index.
The J.P. Morgan Next Generation Emerging Markets (NEXGEM) Index comprises countries that issue hard currency and local currency government and corporate bonds, small and less liquid local currency government bonds and local currency corporate bonds issued by non-NEXGEM countries in emerging markets.
WHAT ARE THE RISKS?
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.