Navigating an uncertain outlook for EM debt
First-quarter recap: a shock to the systemFinancial markets have endured a number of major crises throughout history but hadn’t seen anything quite like the coronavirus outbreak that swept the globe beginning in the first quarter of 2020. The economic lockdowns implemented worldwide to contain the disease’s tragic human toll crushed demand for goods and services, pushed unemployment rates sharply higher and depressed trade, likely triggering a global recession. Adding to the pain in the first quarter was a plunge in crude oil prices, a bellwether for global growth with specific relevance to many commodity-linked EM economies. Oil’s steep drop occurred amid a price war between Saudi Arabia and Russia that exacerbated a global supply glut just as demand for oil was collapsing due to the pandemic.
Oil prices continued to fall in April — with the West Texas Intermediate benchmark dropping below zero on April 20 — before rallying hard in May.
Against that backdrop, EMD sold off aggressively and somewhat indiscriminately in March, with oil exporting countries and their currencies plunging even more rapidly. The JPMorgan Emerging Markets Bond IndexGlobal Diversified (EMBI-GD), a widely used benchmark for hard-currency EMD, fell 13.9%.
That decline marked the worst one-month return for the index since October 2008 and the third-lowest on record, according to FactSet. Of the 74 countries represented in the index, only three (Slovakia, Poland and Lithuania) posted positive returns in March. Angola, Ecuador and Sri Lanka performed the worst. And four countries (Ecuador, Lebanon, Argentina and Zambia) either defaulted or entered negotiations to restructure their debt load.
Outflows accelerate, spreads widenReflecting widespread risk aversion, EMD suffered nearly $40 billion in combined outflows across hard- and local-currency funds in March alone more than half of 2019’s full-year inflows.
This total also dwarfed both the $10 billion of outflows in October 2008 during the global financial crisis and the previous monthly redemption record of $15 billion in June 2013, when bond yields jumped as markets threw a “taper tantrum” in response to the Federal Reserve’s comments about potentially scaling back its quantitative easing (QE) asset purchases.
These outflows caused EM sovereign spreads to widen by more than 400 basis points (bps) in mid-March, to 722 bps, while EM corporates gapped 360 bps wider, to just under 600 bps. Although dramatic, these moves were far more modest than those seen during the 2008-09 financial crisis, when spreads widened by nearly 1,400 bps.
Market illiquidity drives portfolio adjustments, not wholesale changesAdding to the turmoil in March was a severe liquidity crunch, as anxious investors hoarded dollars and trading volumes dried up. During the worst of the squeeze, we focused on maintaining sufficient liquidity in our open-end EM portfolios to meet the risk of potentially escalating redemptions. A lack of adequate liquidity in such stressed circumstances can lead to forced selling of securities positions and thus higher portfolio turnover, which increases transaction costs and can lead to poor trading execution, eroding long-term performance. Those risks are especially acute when bid/ask spreads blow out to unprecedented levels as they did in March, even among the highest-quality EMD segments.
Although April brought improved liquidity and a rally in some of the hardest-hit pockets of EMD, in our view the markets for these assets have yet to return to a fully functional state. To compensate, we’ve put recent inflows and “dry powder” to work by purchasing higher-rated issues, particularly those with significant buffers — such as ample capital reserves — and concessions to secondary markets, to improve the overall quality of our assets without substantially altering portfolio allocations.
In our view, the markets for these assets have yet to return to a fully functional state.
Unprecedented stimulus — will it be enough?In terms of monetary, fiscal and liquidity measures, the global policy response to the economic impact of COVID-19 has been unprecedented (albeit uncoordinated) in speed and magnitude. Key monetary policy highlights include Fed rate cuts as well as commitments to open-ended quantitative easing (QE) from both the Fed and European Central Bank.
On the fiscal policy front, the U.S. government has unleashed nearly $3 trillion (about 15% of GDP) of stimulus. Across the Atlantic, European Union (EU) finance ministers are negotiating a rescue package that could top €1 trillion (about $1.1 trillion). Previously, they agreed to suspend limits on government borrowing, giving the 27 EU countries a freer hand in fighting the disastrous economic effects of the coronavirus.
Reactions to the crisis by EM governments have varied, depending on their policy latitudes. China’s central bank has lowered bank reserve requirements, among other measures, but has yet to reduce interest rates. In contrast, many EM central banks have cut rates substantially while providing various forms of subsidized credit and liquidity support for their respective financial systems and private sectors. And in a radical move — for the developing world, anyway — central banks in Indonesia, Poland, Romania and South Africa have begun QE programs. They’re buying government debt to inject additional liquidity to their respective local markets while providing a backstop for governments to finance their COVID-19 fiscal stimulus packages.
In the U.S., the Fed extended dollar swap lines to nine other central banks, including three in EM countries (South Korea, Brazil and Mexico). To bolster short-term funding and alleviate liquidity constraints, the Fed also conducted a series of $500 billion repo operations in March.
The scope of fiscal support from EM governments has been mixed, although we expect the pace of stimulus to accelerate in coming weeks. China, which aggressively launched stimulus in the wake of the financial crisis, has been notably restrained. While Beijing has announced new infrastructure bills, programs to boost consumer spending have yet to materialize. Other governments in Asia and in central/eastern Europe with current account surpluses have been far more proactive.
Additional sources of support for EM to confront the coronavirus crisis are expected from:
- The International Monetary Fund (IMF), which made available both $1 trillion in financing and its Rapid Financing Instrument, a program that provides financial assistance to meet a wide range of balance-of-payment needs.
- The Asian Development Bank, which tripled its initial COVID-19 response package to $20 billion and approved measures to streamline operations for quicker and more flexible delivery of assistance.
- The World Bank, thanks to its pledge to provide up to $160 billion of financing.
- The G-20, which announced the suspension of about $20 billion of debt payments from the poorest countries belonging to the International Development Association (IDA).
Our EM outlook in a landscape transformed by covid-19Emerging markets overall are still at an earlier stage of the coronavirus infection curve. Considering the higher dependence of many EM economies on trade and commodities, coupled with their fragile health care systems and large “shadow” sectors, the disease-related shutdowns present significant political and economic challenges for EM policymakers. They will be forced to balance the impact of large hits to growth and fiscal accounts with public health and social repercussions. Consequently, we believe political risk will need to be closely watched heading into 2021, as voters digest their respective governments’ responses to the pandemic.
For the broad EM sphere, the economic damage from COVID-19 might turn out to be relatively mild. If this transpires, it will be largely because EM economies, in aggregate, had higher starting levels of GDP growth relative to their developed-market (DM) counterparts heading into the year.
Indeed, in its April 2020 World Economic Outlook, the IMF projects developing-world GDP will contract by a relatively modest 1% this year (compared to a 6.1% decline for advanced economies), and then rebound 6.6% in 2021 (versus 4.5% growth for advanced economies). Our forecasts align with the IMF’s, showing widely divergent outcomes among individual countries. Lower-income economies, and those with limited ability to enact fiscal stimulus, are bound to suffer the most.
Against that backdrop, we believe even more stimulus — and economic reforms — will be necessary both globally and at the individual country level to help economies return to pre-COVID-19 rates of growth. Additional central bank swap lines will almost certainly be required. And as a major bilateral creditor, especially to EM countries, China will need to take a major role in providing financial lifelines.
The combination of deep experience and dedicated focus makes Nuveen’s approach well-suited to navigating EMD during these uncertain times.
Nuveen’s EMD edge: Experience and resultsNuveen has been investing in emerging markets for decades and manages $12.6 billion in EMD assets as of 31 March 2020. Our 16-person EMD team includes portfolio managers with an average of 25 years’ experience in the asset class, along with research analysts and traders dedicated speci-fically to EMD. This allows for a deeper understanding of market dynamics and opportunities to find compelling relative value not only among issuers and securities within EMD indexes, but also in out-of-benchmark, less covered areas of the globe.
Together the team has weathered multiple market cycles and crises, with a track record of delivering strong risk-adjusted returns. They have achieved these results through a disciplined investment process focused on downside risk management and efficient allocation of active risk. The combination of deep experience and dedicated focus make the team’s approach well-suited to navigating EMD during these uncertain times.
Given the maturation and diversity of the asset class, the current crisis does create significant and unique opportunities, despite COVID-19’s devastating human and economic toll. In fact, our core belief that EMD should not be considered a monolithic asset class has never been more applicable than it is today.
Our core belief that EMD should not be considered a monolithic asset class has never been more applicable than it is today.
Lastly, we’ve uncovered EMD market segments where we believe valuations have overshot and are inconsistent with fundamentals. Current market pricing implies a very high rate of defaults that may be unlikely to materialize, based on our analysis of default levels during prior crises.
The benchmark for the Emerging Markets Blend Composite is the JPMorgan Emerging Markets Bond Index Global Diversified (EMBI®-GD) Index. The EMBI® Global Diversified Index is a uniquely weighted version of the EMBI® Global Index. It limits 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 Index are identical to those covered by the EMBI® Global Index (The EMBI® Global tracks total returns for U.S. dollar denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady bonds, loans and eurobonds).The benchmark for the Emerging Markets Local Currency composite is the JPMorgan Government Bond Index Emerging Markets Global Diversified (GBI-EM) Index. The JPMorgan GBI EM-Global Diversified indexes are comprehensive emerging market debt benchmarks that track local currency bonds issued by governments of emerging markets. The source of all benchmark returns is JPMorgan.
A word on risk
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