Where to, Emerging Markets?

Brandywine Global provides an outlook for emerging markets with focus on Asian opportunities.

    Carol LyeAssociate Portfolio Manager/Senior Research Analyst, Brandywine Global

    Emerging market bonds rallied spectacularly in the last two months of 2020. Capital flows finally made the shift into emerging markets, buoyed by extremely abundant global liquidity conditions, China’s economic recovery, rising global trade, and prospects of global vaccinations. Against this backdrop, bond valuations have tightened for most emerging markets while currencies remain somewhat cheap on a valuation basis. Will these tailwinds continue to propel emerging markets in 2021 given the chase in yields, or will these markets face new challenges as developed markets re-normalize?

    Emerging Market Average Real Effective Exchange Rate*Emerging Market REER*, As of 2/2/2021

    *Equal-Weighted Average of 18 Emerging Market Countries Excluding China

    Source: Macrobond

    A Hint of Things to Come?

    January gave investors a feel of what a withdrawal of liquidity would be like. Real rates in the U.S. seemed to be bottoming while the People’s Bank of China (PBOC) toyed with the withdrawal of liquidity in the overnight repo markets. Given that market sentiment and investor positioning were reflecting an optimistic view that the accommodative backdrop would continue for an extended period, this unexpected glimpse of the potential for higher rates and tighter liquidity—possibly sooner than expected--shook financial markets. Nonetheless, there are reasons to believe that emerging market tailwinds could persist.

    Still, Signs of Support

    Despite talks of tapering, the Federal Reserve (Fed) remains committed to its new policy regime shift of average inflation targeting, and liquidity remains ample. Moreover, emerging markets thrive on burgeoning global growth and global trade. In this aspect, fears of a collapse in China’s credit impulse may be overstated at this point. While the Chinese credit cycle is turning with the Chinese government refocusing on stabilizing leverage in the system, the Chinese economy needs to overcome the second wave of the virus. Therefore, fiscal stimulus appears likely be supportive of the economy this year. Indeed, fiscal impulse leads China’s Purchasing Manager Index (PMI), and the current trajectory implies China’s PMI will likely stay above 50 this year. That said, one may need to pay more attention to the credit impulse after the Chinese Communist Party’s 100th anniversary meeting in July.

    Excess Liquidity Year-over-Year Growth, As of 12/1/2020

    Source: Macrobond

    China's Fiscal Impulse and Manufacturing Purchasing Manager IndexLeft: % GDP, Right: Index, As of 1/31/2021

    Source: Macrobond

    Within the Asia region, there are some potential beneficiaries of Chinese and emerging market stability this year. Among these, the Indian rupee stands out. From a bond perspective, Chinese bonds remain positive.


    India appears to have overcome the COVID-19 pandemic quite successfully. Recoveries continue to outpace new cases. Vaccinations have risen to 270,000/day, although it may take until mid-2022 to vaccinate two-thirds of the Indian population. Despite that, overall industrial activity has almost fully recovered. Services activity is now roughly at 95% of pre-COVID-19 levels. Over the past two quarters, India has seen strong foreign direct investment and equity inflows. Meanwhile, the central bank has been intervening to keep the currency on the cheaper end. However, with the amount of liquidity circling in the economy, the central bank may at some point be more comfortable with intervening less.

    The medium-term story for India is even more important and suggests an increasingly brighter outlook. The government has revived its “Make in India” national program, providing more incentives for foreign companies to invest in the country. In the latest fiscal budget, the focus was on increasing infrastructure capital expenditures (capex) as well as establishing an asset management company to take over stressed debt from banks’ balance sheets. India’s investment-to-gross domestic product (GDP) ratio has been falling over the past decade. This investment push along with the clearing up of banks’ balance sheets may be a booster shot for growth.

    India Balance of Payments: Net Direct Investment 10m Rupees, Not seasonally adjusted, As of 9/30/2020

    Source: Reserve Bank of India, Haver Analytics


    The wide yield spread between Chinese government bonds and U.S. Treasuries is by now a well-known story. That spread has widened further as the Chinese economy has been the first to recover from the COVID-19 crisis. Chinese yields are now back to pre-pandemic levels. Going forward, that spread will likely narrow as the U.S. economy starts recovering at a faster pace. However, China may also keep rates at a relatively high level to encourage portfolio inflows to support the current account as the country moves toward domestic circulation. A relatively stable Chinese renminbi with a decently high carry for an investment grade-rated country is a good reason to remain positive on Chinese government bonds. In the event of slower-than-expected Chinese growth, hedged Chinese bonds could serve as a safe haven as well.

    Chinese 10-Year Government Bonds and U.S. Treasuries Spread%, As of 2/9/2021

    Source: Bloomberg

    Putting It All Together

    Emerging markets will need to contend with the ebbs and flows of global liquidity as it may start to wane this year. However, a stronger global recovery driven by the developed markets, coupled with a relatively stable China, could remain supportive. Furthermore, the U.S. dollar will continue to be crucial to the emerging market story. The dollar appears likely to fall further in the first half of 2021, but with more volatility. Emerging markets, which still offer relatively higher yields compared to developed markets, may continue to generate decent returns for fixed income investors if these parts continue to work together this year.

    The real effective exchange rate (REER) is the weighted average of a country's currency in relation to an index or basket of other major currencies. The weights are determined by comparing the relative trade balance of a country's currency against each country within the index. REER is used to evaluate how a currency is fluctuating against many others at once, and is also used in international trade assessments.

    A repurchase agreement, or repo is a contract under which the seller commits to sell securities to the buyer and simultaneously commits to repurchase the same (or similar) securities from the buyer at a later date (maturity date), repaying the original sum of money plus a return for the use of that money over the term of the repo.

    The National Bureau of Statistics (NBS) Manufacturing Purchasing Managers Index (PMI) released by the China Federation of Logistics and Purchasing studies business conditions in the Chinese manufacturing sector.

    The carry of an asset is the return obtained from holding it (if positive), or the cost of holding it (if negative) where you earn the spread between borrowing a low carry asset and lending a high carry one. A currency carry trade is a strategy whereby a high-yielding currency funds the trade with a low-yielding currency, attempting to capture the difference between the rates.



    Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

    Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

    U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.