Emerging Markets Debt - 2016 OUTLOOK

We expect 2016 to be another challenging year for EM. However, the asset class is likely to perform stronger in the second half of the year, as the headwinds to it – such as the continued decline in oil prices and the depreciation of EM currencies – are likely to subside.

A difficult context but we believe this sell-off is overdone

Year-to-date, the global equity and riskier fixed income markets have experienced significant corrections while safe-haven assets have rallied. The depth of the correction in risky assets was unexpected. The Brent fell by 6.6% in January, following a 68% decline from its June 2014 high of $115/bbl through December 2015. The S&P 500 and Euro Stoxx declined by 5% and 6.8% respectively, entering bear-market territory on growing recession fears in the US. By contrast, the 10-Year US Treasury yield fell from 2.27% to 1.92%, as markets began to price out a resumption of Fed rate hikes in 2016.

This volatility was driven by the same combination of risk factors that has weighed on emerging market debt and risky assets since 2015:

1. US monetary policy normalization and US Dollar strength,
2. the China slowdown and related worries over policy errors around the liberalization of the exchange rate regime, and
3. the supply glut in the industrial metals and energy markets and resulting price declines.

Since the beginning of the year, we have observed tentative stabilization for at least two of these risks. The risk sell-off in January/February and the mixed US macro data have rendered a March hike in the Fed funds rate highly unlikely and raised the probability of an even more gradual hiking cycle; this has led to a weaker dollar. In addition, Chinese policymakers have temporarily managed to stabilize the RMB with a slightly lower-than-expected loss of FX reserves.

We expect a stabilization of current levels in the near term. Current macro data does not support the case for a US and global recession, key technical levels have held for several major markets and EM debt has become very attractive. A more sustained recovery in EM risk sentiment, however, is likely to remain elusive in the absence of more clarity on macro fundamentals.

Short-term headwinds still in place

EM fundamentals remain challenged by the China slowdown, the marked decline in global trade, and the commodity exposure of the asset class. The resulting deterioration in sovereign and corporate balance sheets requires strong responses from EM policymakers, something we have witnessed only selectively. A number of smaller commodity exporters, typically open economies, are particularly affected and have resorted to the IMF as a lender of last resort, with more likely to follow. Some of these have undergone sustained and positive adjustments, with others failing to implement reforms. We do not currently anticipate sovereign defaults in 2016, with the possible exception of Venezuela via its state-owned oil company PDVSA, where current prices are already below assumed recovery value.

We consider EM valuations as attractive

At 493bps, the EM hard currency spread over US Treasuries is trading above the post-global financial crisis high of 468bps (October 11) and the current EM hard currency yield-to-maturity of 6.64% is at levels (above 6%) which have historically attracted inflows. The picture for EM local currency debt is similar. EM currencies have undergone significant corrections (the GBI-EM Global Diversified currency component has declined by 50%+ cumulatively since 2010) and very few EM currencies currently screen expensive. Carry is also attractive, with local yields trading around 7%, inflation well-behaved and most central banks retaining an accommodative stance

EM technicals are mixed. The hard currency sovereign net supply (gross supply adjusted for coupons and redemptions) is negative, which is supportive. Investor positioning is defensive and cash levels are generally high. However, flows to the asset class have not yet reversed their downward trend of the past half year. Outflows from hard currency debt have, year-to-date, accelerated, accounting for two-thirds of redemptions YTD ($4.9bn total EMD fixed income outflows YTD), and are now running higher than those for local currency debt. However, the magnitude and pace of outflows is unlikely to persist, as valuations have become more attractive. We expect flat-to-small positive flows in emerging market fixed income over 2016, in line with the 3-4% forecasted one-year returns for both hard and local currency debt.

Conclusion

While the outlook for EM is not straightforward, headwinds are likely to clear and we are more optimistic for the second half of 2016. In hard currency, we expect credit differentiation to play an increasingly important role, favoring our relative value investment approach. Our largest overweights are in Argentina (idiosyncratic recovery story driven by political transition) and Eastern European commodity importers, which offer upside around near-term rating upgrades (Hungary) and structural reforms (Croatia). We have a balanced exposure to select commodity exporters, with attractive volatility-adjusted returns over a 12-month horizon. In local currency, we tactically bought back local rates and EM currencies on a view that the global market corrections and US Dollar strength have gone too far. We expect EM rates to outperform EM currencies again in 2016. The outlook for EM rates is particularly positive, given the mix of soft growth, manageable and declining inflation in a number of large EM high-yielding countries and accommodative EM monetary policies, and we will be looking to add to local duration once we identify a more decisive turnaround in EM risks.

Sources for all referenced data: Bloomberg; JP Morgan, Candriam. As per 12/02/2016