The long awaited correction in fixed income markets has begun, what does it mean for emerging market debt and what are the catalysts for a rebound?
The first part of the summer 2015 fixed income/currency sell-off has begun, with US Treasury and German Bund yields rising sharply. While developed markets yields have been selling off, emerging markets debt has outperformed on a relative basis. Emerging markets debt’s relative outperformance has largely been due to continued strong technical factors in the asset class. External debt issuance is expected to remain negative on a net basis in 2015, thus continuing its two-year trend. Meanwhile, local markets, which are now in a multi-year bear cycle, have already seen many investors flee the asset class as volatility has remained high. This has resulted in an under-owned asset class in which the “weak hands” have already departed.
Reactions in emerging markets debt tend to lag those in global markets on both the upside and the downside. Following the slide in global yields in January, it took one and a half months before emerging markets debt followed suit. In a similar manner, we believe that emerging markets will likely catch up to recent developed markets weakness in the weeks ahead
We have repeatedly been calling for a correction in emerging markets debt over the last three months. However, now that we believe the sell-off has begun, we have shifted our attention to uncovering potential triggers for a rebound in emerging markets debt. There are a number of positive catalysts on the horizon, as we describe below.
Scenario 1
The sell-off is large enough that investors will finally be adequately rewarded for taking risk. The asset class could easily reach the point where returns cross the “value threshold”. Emerging markets debt could have attractive valuation levels sooner than when the fundamentals actually recover.
Scenario 2
The nascent recovery in the US economy is complemented by a slow, but steady recovery in European growth. Better growth from the two largest engines of global demand should more than offset the continued, managed slowdown in China. More importantly, developed markets growth, when it reaches a critical juncture, actually becomes good for emerging markets growth and currency valuations. A falling US current account has been categorically negative for emerging markets currencies against the US dollar. In fact, since 2011, when the US current account deficit troughed at -3%, emerging markets currencies have depreciated by more than 30%. So, when will the tide finally turn for the asset class? Very simply, when US growth reaches a critical juncture where we begin to see a worsening US current account balance.
Scenario 3
A commodity price shock to the upside, from supply shortages or China stimulus, boosts emerging markets as a whole. While this is a low probability event, it warrants repeating that, as much as emerging markets countries have developed over the years, they still exhibit a strong positive growth correlation to commodity prices. With what has been a multi-year commodity bear market for the last several years, expectations remain very low and even small advances would be a welcome change.
Looking ahead
The process of a market correction is never fun. Cooler heads are not prevailing as anxieties build and worst fears are analyzed and tested. However, this type of market correction is within the normal ebb and flow of the market. We fully expect the market correction to continue for a couple of months , but now that it has started, we have turned our focus to looking for the rebound.
Source: Lazard
