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William Blair Commentary: Positive 2020 Outlook for Emerging Markets Debt

A number of factors lead us to think the outlook for emerging markets debt (EMD) is positive. Last year's performance was clearly above average (primarily driven by falling U.S. Treasury yields, rather than EMD risk premia compression).

This year's overall balance of factors looks marginally more constructive than last year's, based predominantly on better economic growth in emerging markets, but also on low inflation, positive EMD fundamentals, solid technical conditions, and attractive valuations.


Global Market Conditions Support EMD

We have a constructive outlook for EMD as the favorable combination of factors that drove the strong performance of the asset class in 2019 remains in place.

The global economy should continue to expand at a healthy pace, and economic activity in emerging markets is expected to accelerate into 2020.

We acknowledge that the events over the past month in China are likely to weigh on economic growth in the short term, with risk of a more protracted and widespread impact. However, we expect that the response from monetary authorities will somewhat mitigate the impact on emerging markets debt. Historically, incidents of this nature have had a short-lived impact on asset-price volatility. That said, once evidence emerges that the coronavirus spread has been contained, the recovery could be sharp in nature.

We believe that U.S.-China trade tensions will moderate ahead of the U.S. presidential elections, inflation will remain subdued, and monetary policy will remain accommodative. Low global interest rates and ample liquidity conditions should continue to underpin investors' sentiment throughout the year.

But while our outlook for the year is constructive, we are cognizant of risks: geopolitical tensions in the Middle East, the U.S.-China trade war, and the U.S. presidential election offer ample scope for volatility.

EMD Fundamentals Remain Positive

Economic activity in emerging markets is expected to accelerate in 2020 as the lagged impact of monetary policy stimulus implemented in the past year starts to materialize.

We expect the growth differential between emerging and developed markets to expand in the coming quarters.

A benign inflationary backdrop should continue to allow central banks to provide additional monetary stimulus as the level of real interest rates in emerging markets remains high.

Moreover, external balances remain healthy in most places, fiscal and debt dynamics are at manageable levels, and the financial sector is well capitalized and regulated.

We expect default rates to remain at historically low levels.

Corporate credit fundamentals should remain stable as a slow capex cycle is unlikely to deteriorate leverage, in aggregate.

Solid Technical Backdrop

We expect the continuation of strong investment flows into EMD. There is strong evidence that capital flows into emerging markets intensify in periods when the growth differential between emerging and developed markets accelerates.

Moreover, flows into EMD should continue to be supported by ample global liquidity conditions and low global rates.

Investment flows into EMD portfolios are expected to be around $30 billion in 2020; in the meantime, net refinancing needs in the hard currency space, including sovereign and corporate credit debt, should remain relatively low, forecasted at close to $30 billion in 2020.[1]

Valuations Remain Attractive

While slightly below the average of the past five years, hard currency sovereign and corporate debt spreads remain attractively priced relative to those of developed market credit.

We see particular value in the sovereign credit high-yield space, where some frontier market names trade at cheap levels.

We also see value in selected names in the corporate credit space.

In the local currency space, emerging markets currencies remain fundamentally undervalued, and the real interest-rate differential between emerging and developed markets is at historically high levels.

A Solid Year?

All things considered, we expect a decent 2020 after a stellar 2019. While investors will likely confront bouts of volatility during the year, we tend to see those events as an opportunity to buy undervalued, fundamentally strong assets. The double-digit returns of 2019 are unlikely, but we still expect mid- to high-single-digit returns in 2020.

Details are provided in future posts posts, which address, in turn, hard currency sovereigns, hard currency corporates, and local currency bonds.

Emerging Markets Debt Outlook

Part 2: Hard Currency Sovereigns: A Solid Outlook

Part 3: Hard Currency Corporates: Stable Footing

Part 4: Local Currency Bonds: Showing Promise

[1] Source: JP Morgan Emerging Markets Outlook and Strategy for 2020 (November 25, 2019).

Marcelo Assalin, CFA, is a portfolio manager on and head of William Blair's Emerging Markets Debt team.

Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks. These risks may be enhanced in emerging markets. Investing in the bond market is subject to certain risks including market, interest rate, issuer, credit, and inflation risk. Rising interest rates generally cause bond prices to fall. Sovereign debt securities are subject to the risk that an entity may delay or refuse to pay interest or principal on its sovereign debt because of cash flow problems, insufficient foreign reserves, or political or other considerations. High-yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Diversification does not ensure against loss. Any investment or strategy mentioned herein may not be suitable for every investor. Past performance is not indicative of future results.

This article first appeared on GuruFocus.