15 DEC


Fixed Income , Topics

Better fundamentals, Attractive valuations but differentiation is key


Emerging markets continue to benefit from improved fundamentals after two years of solid performance on both the hard currency and local currency debt markets (in USD terms). Growth has improved and more broad-based and strong EM export activity has helped stabilize and even correct current account deficits, which had been a source of vulnerability for the asset class since 2013. In terms of valuation, though EM HC and LC yields have rallied close to their post-2008 highs, they continue to remain relatively appealing, at 5% for EMD HC and 6% for EMD LC.

While the macro-economic outlook is clearly favourable, there are external risks such as specific events and election risks that need to be taken into consideration. Indeed, emerging markets face a politically charged calendar as several countries (including South Africa and most of Latin America) will be holding elections while geopolitical tensions over North Korea and in the Middle East are very much present. The universe does face some potential risks, namely a sharp increase in US treasuries as a result of uncertainty surrounding US macro and the pace of rate hikes.

It is important to note that the EMD universe is dollar-denominated and hence, for Euro-based investors, it is important to pay attention to the EUR/USD FX rate as this could have a significant impact on their investments. In the current context of a strengthening Euro, investors are better off keeping their investments in Euros, and hence hedging the EUR/USD risk.

On the Hard Currency Debt front, we are constructive on commodity exporters as EM credits have decorrelated from the tepid oil-price evolution (Angola, Azerbaijan, Ecuador, Kazakhstan) and specific idiosyncratic re-rating stories like Argentina, Ukraine, Egypt and Ghana. Our underweights include US treasury-sensitive credits with tight valuations such as Panama, Peru, Chile, Uruguay, the Philippines and Poland. We are also underweight South Africa, which is suffering from tight valuations, domestic political transition risks, downgrade risks, insufficient fiscal adjustment and weak growth.

Focus on Fundamentals and Idiosyncratic Risk, Favour Flexibility and Differentiation

All in all, the fact that the US Fed and the ECB have both entered the tightening phase is clearly a significant change vis-à-vis markets that had almost gotten used to central bank support. In this context, Fixed Income investors will have to pay closer attention to fundamentals and specific factors that will rise to prominence. Furthermore, some reversal of the massive QE measures is likely to take place with the rise in low yields and spikes in a visibly suppressed volatility. Such a context will favour differentiation and require a certain degree of selectivity. We might not be in for a bond market crash, but flexible, active and selective management will be key to navigating the challenges that lie ahead as we bid bye-bye to central bank support and focus on fundamentals.