The Diverging Fortunes of Emerging Markets

Brandywine Global: The COVID pandemic highlights the quality differentials within the EM debt universe.

    Alberto J. Boquin

    Alberto J. Boquin Research Analyst

    This year’s COVID shock accelerated a secular decline in interest rates around the world. Emerging market (EM) rates are no exception. The yield on the JP Morgan Emerging Market Local Currency Index (GBI-EM) declined to a series low of 4.6% compared to a 6.3% average in the prior decade. However, looking at the index can be misleading as there is plenty of dispersion beneath the surface. Higher-quality EMs have seen their interest rates converge toward developed market levels, but there remains a posse of lower-quality EMs where equilibrium rates continue to hover around the high-single digits (Chart 1).

    Chart 1: GBI-EM High and Low Yielders Yield to Maturity %, As of 6/18/2020

    Source: Bloomberg Finance LP. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

    What differentiates the two groups? For starters, inflation-fighting credentials. It’s one thing to look at inflation in the present or even forecasts a year out. These are influenced by a number of temporary factors including the stage of the domestic business cycle, global oil markets, and currency passthrough inflation. A cleaner measure for inflation credibility is the willingness of markets to lend a country money for a nominal fixed rate at long maturities. Some EMs have weighted average maturities of their debt of over 10 years while some have been forced to borrow at much shorter terms. See Chart 2.

    Chart 2: Weighted Average Maturity of Local Debt Years, As of 6/18/2020

    Source: Bloomberg Finance LP. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

    Fiscal policies matter too. A central bank’s ability to fight inflation is constrained by the sovereign’s ability to weather an economic slowdown and service its debt. If monetary policy is deemed unsustainable because of the impact it has on the fiscal outlook, then markets will move to price in a reversal of low policy rates. This is particularly prominent in today’s current market environment. While many EM central banks have moved rates to their effective lower bound and pledged to keep rates low as long as necessary, markets are pricing in hikes in a number of countries one year out (Chart 3).

    Chart 3: Policy Rate Moves Priced Within 2 Years BPS, As of 6/18/2020

    Source: Bloomberg Finance LP. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

    Last but not least, some EMs have earned the benefit of the doubt due to the quality of their institutions. While it is always tempting to be charmed by a “rock star” finance minister or central bank governor, a country that relies on a single individual for credibility is a country whose fortunes can easily turn. Properly established institutions should garner respect regardless of the leadership.

    The distinction between the good and bad EMs is likely to widen in coming years. As we move past the initial COVID shock, markets will likely move to further distinguish between EMs that will course correct to reverse emergency measures and those that just used the pandemic as an excuse for further fiscal and monetary slippage. Quite a few large EMs are stuck in the middle but are likely to head in one direction or another soon.


    DEFINITIONS

    COVID-19 is the World Health Organization's official designation of the current novel coronavirus disease. The virus causing the novel coronavirus disease is known as SARS­CoV-2.

    Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.

    The JPMorgan Government Bond Index-Emerging Markets (GBI-EM) indices are comprehensive emerging market debt benchmarks that track local currency bonds issued by Emerging Market governments.

    One basis point (bps) equals one one-hundredth of one percentage point.

    A central bank is a national bank that provides financial and banking services for its country's government and commercial banking system, as well as implementing the government's monetary policy and issuing currency.

     

    WHAT ARE THE RISKS?

    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.