It has been a tough first half of the year in 2018 for investors in risk assets.
Only the US Technology and Small cap Equities produced any form of positive returns up to to the end of June, and even this was barely profitable.
The Emerging Market (EM) bond performance was particularly dismal.
The EM Corporate (JP Morgan CEMBI Broad) and Sovereign (JP Morgan EMBI) registered returns of -2.8% and -5.2% respectively.
With such poor showings, the EM bond market is off to its worst first half of the year on record.
Things can only get better
The poor first half was down to a toxic combination of rising interest rates, a strong US dollar, trade tensions and robust oil prices.
The US Fed Quantitative tightening was the pre-eminent factor, though. While a rise in rates was widely expected, few predicted such a rapid increase of rates.
Over the rest of the year, we believe that rates should be less of a drag on how well fixed income does.
While we expect the strength of the US dollar to remain a headwind, we do not expect the rate of EM currency depreciation that we saw in the first half of 2018.
Naturally, trade tensions remain the wild card as an all-out trade war is certainly not out of the realm of possibility.
The second half of the year has started with several top-down and bottoms-up factors still underpinning this assets class.
Overall, it is positive momentum for global EM, although growth expectations in a few countries, such as Brazil, have been reduced.
Balance sheets have shown improvements over the past few quarters with default rates still below historical averages.
At the same time, valuations are more compelling as credit spreads have changed considerably from the February 2018 tights.
These two factors, combined with our analysis that interest rates should have less of a negative impact than in the first half of the year, drive our cheerier outlook for the asset class till the end of the year.
Here are some factors to keep in mind:
Prefer High Yield to Investment Grade
In the first half of the year, EM Investment Grade outperformed that of EM High Yield, the exact opposite of what we were seeing in the Developed Market.
We do not see this as a secular trend of a flight to quality, but rather as a result of idiosyncratic events (largely sovereign related) in a number of high profile countries.
In the next six months, we see positive bottoms-up fundamentals coming more to the forefront. Balance sheets have improved over the last few quarters, defaults remain below historical averages, and the percentage of ‘stressed’ bonds remains low.
From a valuation perspective, High Yield remains more compelling, with the differential between EM High Yield and EM Investment Grade spreads easing back to late 2016 levels after reaching all-time tights in February 2018.
Maintain a modest duration underweight
We are of the view that there will be quarterly Fed rate hikes through to at least until the end of 2019. As such, we advocate maintaining an overall portfolio index which is mostly below the index.
This view is based on a general view that the shorter end of the government curve will bear the brunt of the interest rate increases.
We would also not totally avoid longer (30-year) bonds.
With low absolute dollar prices and higher credit spread curves, these make interesting entry points, especially for investors with longer-term views.
Favour Asia, not so much Latin America
Our call for higher investments in Asia are due to relatively political stability, stronger country GDP growth and more compelling valuations, particularly in High Yield.
Latin America, the darling of EM investors for much of the last two years, now appears far less appealing given the political and economic challenges of the two largest players – Brazil and Mexico.
Latin America also sports the highest duration, which will likely weight on performance in an environment of rising interest rates.
Within Latin America, pick Mexico over Brazil
Brazil and Mexico together account for more than 60% of the region’s GDP.
With looming elections in Brazil later this year, the thesis of economic momentum coupled with fiscal reforms appear dead in the water.
In Mexico, a new president was elected with a mandate that appeared unthinkable as recent as just a few weeks ago.
While President Andrés Manuel López Obrador’s ultimate policy is currently unknown, we believe there is a greater possibility of a market-friendly outcome in Mexico compared with Brazil.
Prefer Middle East over Russia and Turkey
In the Central and Eastern Europe, Middle East and Africa (CEEMEA) region, we suggest an overweight in the Gulf Cooperation Council states compared to Turkey and Russia.
In Turkey, President Erdogan has received a popular endorsement to enhance his already near autocratic powers and is re-making his Cabinet in his image.
Russia appears still mired in a multi-year on-and-off sanctions cycle.
Even though Africa is a small part of the EM bond universe, we suggest an overweight there as well.
Opportunities in China and Indonesia
Valuations in Chinese credit, especially High Yield, are at multi-year highs. However, careful credit selection is still crucial.
We prefer China property over China industrials, given higher idiosyncratic risks and corporate governance concerns for industrials.
Within property, we suggest focusing on larger, stronger and higher quality entities.
If you are considering Chinese State Owned Entities (SOE), we advocate those of strategic importance and have clear and visible ownership.
It is the opposite in Indonesia, where we prefer industrials (commodities) over property.
This is due to supportive commodity prices, improved earnings and natural foreign exchange hedge.Disclaimer applicable to recommendation
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