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3 Problems Could Pinch EM Bond ETFs in 2019

This article was originally published on ETFTrends.com.

Rising external financing costs and current account deficits are among the factors plaguing emerging markets debt this year, pressuring exchange traded funds such as the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) and the PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) along the way.

EMB tracks the J.P. Morgan EMBI Global Core Index, a market-cap-weighted index. Potential investors should note that since it is a cap-weighted index, countries with greater debt will have a larger position in the portfolio.

Some analysts and market observers believe the scenarios confounding emerging markets bonds this year could linger into 2019.

“The impact of tighter US monetary policy, a strengthening dollar, and risks to global trade and growth will continue to be felt in 2019,” said Fitch Ratings in a note out Monday. “EM vulnerabilities are reflected in Fitch's sovereign rating Outlooks and recent rating actions. Of the 15 sovereign ratings on Negative Outlook, only three are in developed markets.”

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Cloudy With A Chance of Downgrades

Several emerging markets have been subject to credit rating downgrades or bearish outlook revisions this year. For example, Fitch downgraded Argentina's credit rating while issuing two downward outlook revisions on embattled Turkey.

The U.S. dollar, which has been strong for much of this year, could remain that way next year, sapping the allure of dollar-denominated emerging markets debt in the process.

“Further dollar appreciation and tighter global financial conditions are likely to discourage capital flows to EMs. The rise in foreign-currency EM debt in recent years exacerbates the impact of a rising dollar on the availability and cost of financing for EMs. The direction of the dollar is critical for EMs and is inversely correlated with EM sovereign ratings,” according to Fitch.

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Some emerging markets have boosted interest rates this year, but more monetary tightening could be required before those efforts bear fruit in terms of shoring up weak currencies. However, higher interest rates in the developing world carry another set of risks.

“For example, interest rate rises may help contain pressure on EM currencies, but monetary tightening from a relatively loose starting point is another barrier to growth,” said Fitch. “And while many EM central banks typically say that they only intervene in currency markets to smooth volatility, data suggests that they may spend reserves to prevent even greater depreciation, depleting external buffers.”

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