What should we expect this year?
At the start of each year we consider our return forecasts for Emerging Market assets over the next 12 months, in order to frame our expectations for taking active risk across portfolios. After a challenging year for EM in 2018 we saw negative returns across sectors. The move has created some interesting value opportunities; in particular with hard currency sovereign yields on average over 1.5% higher than a year ago, whilst many EM currencies have never been at such cheap valuations when considering their real effective exchange rate.
When we consider the risks facing the asset class this year, many of the headwinds affecting sentiment through 2018 are subsiding. In the US, the Federal Reserve’s interest rate hiking programme may be coming towards its end, limiting the impact of rising rates and a strong US dollar on emerging economies. We also believe that trade tensions may ease, with both sides of the Pacific having a vested interest in avoiding economic damage from tariff impositions. The backdrop has poised EM for a potential recovery in 2019; and year-to-date we have already seen a strong start across hard currency and local markets – this is a trend we believe may continue for the year.
We consider the yield characteristics of JP Morgan EM indices for hard currency and local debt markets at the start of the year, and then consider the key risks which will drive performance over 2019:
- EM Hard Currency: direction of sovereign spreads + US treasury yield movements
- EM Local Currency: direction of EM local yields + EM currency strength versus US dollar
For testing return outcomes under several different scenarios we consider a range of moves in these variables, for example in hard currency markets we assess the impact of spreads compressing 100bps lower, in 25bp increments, from their start-of-year level, but also consider the opposing result, if spreads were to widen to a higher level. We combine this with the impact of movements in US treasury yields (given the US duration sensitivity of hard currency bonds) simultaneously and we can therefore build a matrix of different potential return outcomes.
We must assign probabilities to each outcome in order to understand the most likely result, depending on our active views of where the market may end up by year-end. We do not believe it will be another year of the same negative pressure on EM that we saw in 2018, therefore we assign a low probability of sovereign spreads moving significantly wider in the matrix.
An overall probability-adjusted return can be calculated from combining our probability forecasts with the return impacts from the various scenarios – this forms our best-estimate for the index returns we believe may be achievable this year – if our assumptions on the direction of markets play out correctly.
EM return matrix 2019 (in USD terms)
If nothing changed in the market for 2019, across sovereign spreads, US yields, and in EM local markets, we can follow the zero lines to the middle of each matrix above to understand the index yields that would be harvested as income for the year. For example, the hard currency income accrual would be 6.9%, and for local currency 6.4%.
Our highest probability outcomes in the matrices are highlighted within the red boxes. We believe that hard currency sovereign spreads can compress this year by 25-50 bps versus start-of-year levels; and we believe longer-dated US treasuries are more likely to face downward pressure than any move higher. In combination this is expected to drive strong appreciation in EM asset prices – with the potential for double digit returns under some scenarios (in USD terms). For the local currency index we expect some strengthening of EM currencies to occur alongside a modest recovery in EM local rates (ie. yield compression of 0-25bp), again driving a potential double-digit return outcome in USD-unhedged terms.
Overall we believe the outcomes are skewed to the upside for potential returns from EM assets in 2019.
All scenario analysis has been conducted from a US dollar basis, and therefore investors pursuing allocations from different regions (eg. a Euro-based investor with a currency-hedged allocation), would face additional hedging costs that may alter the scenario outcome significantly.