Market Is Constructive
- Global Trends: Since the start of the year, markets have priced in further rate hikes by the Fed on the back of stronger economic and stickier inflation data. This has led to a recent increase in volatility as measured by the MOVE index, which tracks the volatility of US rates markets. We believe the uptick in volatility presents an opportunity. We expect the Fed will again revise up its rate path projections at the March FOMC meeting, bringing the Fed and market into greater alignment. Greater alignment, post repricing, may reduce uncertainty and spur risk taking.
- EM Fundamentals: EM monetary policy tightening over the past two years support EM disinflation trends, while China’s re-opening and a consumption-led recovery have positive spillover effects for EM growth (Figure 1). All else equal, flows tend to follow high growth segments of the global economy. As per the latest JP Morgan forecasts for 2023, EM ex. China GDP growth is expected to outpace that of developed markets by approximately 2% and developed market growth is expected to be essentially flat (Figure 2). We have recently seen a number of growth estimate revisions pointing to higher China and Asia growth which should feed through to regional peers and broader EM.
- Relative Value: EM fixed income continues to trade at attractive valuations to comparable public credit markets. EMBI (half-IG, half-HY) continues to trade at a 150 bps (“basis points”) spread pick-up to a comparable basket of U.S corporate credit. The EM high-yield segment in particular appears relatively cheap, with spreads for this segment trading 350 bps over U.S high yield (Figure 3). The yield of our asset class continues to hover close to its highest point in 10 years (Figure 4).
Technicals are Supportive
- Flows: Projected cashflows from outstanding EM external debt will be uniquely elevated for the next several months. The reinvestment of these proceeds provides natural demand for the asset class (Figure 5). More importantly, managers will seek to reinvest these proceeds in on-the-run liquid benchmarks and newly issued maturities that benefit from a high degree of liquidity and current yield. We expect projected cashflows to serve as a tailwind.
- Supply: The first month of the year marked a reanimation of the new issue market, offering investors opportunities to effectively rebalance and to capture concessionary pricing. Per JP Morgan estimates, sovereign supply in 2023 is expected to reach $105 billion, providing an expanded investment universe. At the same time, sovereign net financing- or the projected supply minus the cashflows from existing debt- is projected to be negative for a second consecutive year. Thus, while we expect to see more opportunities in primary markets, we still see this dearth of net-supply as highly constructive for outstanding valuations (Figure 7).
Certainly, risks remain with regards to the direction of rates driven by Fed policy action resulting from inflation metrics, the uneven nature of the global economic recovery post-Covid and the conflict in Ukraine, among others. Furthermore, timing the market will always be an imperfect exercise. That said, for a strategic allocation, we believe conditions remain highly constructive based on fundamentals, valuations, technicals and flows.
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Definitions of Indices Referenced:
The J.P. Morgan Emerging Markets Global Diversified Index (EMBI Global Diversified) is a uniquely weighted version of the EMBI Global. It limits the weights of those index countries with larger debt stocks by only including specified portions of these countries’ eligible current face amounts of debt outstanding. The countries covered in the EMBI Global Diversified are identical to those covered by the EMBI Global.
The ICE BofA MOVE Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options. It is the weighted average of volatilities on the CT2, CT5, CT10, and CT30.