In June 2023, hard-currency emerging market debt1 returned +2.23%, while local-currency emerging market debt2 returned +3.26%. For emerging market corporate debt3, the total return over the period was +1.08%.
In hard-currency emerging market debt (EMD), there was a big positive contribution from spreads, which tightened by 45 basis points (bps) over the month. This comfortably exceeded the negative impact from Treasuries, with the US 10-year yield rising by 20bps to 3.84%. Higher Treasury yields were reflective of the strength of recent US economic data, which hardened expectations for further US monetary tightening, despite the pause in rate-hiking in June. Stronger US economic data and the reduced risk of US recession are positive for global economic growth, which helps explain the strong spread performance of emerging market (EM) bonds in June.
In local-currency debt, a positive return from local EM bonds was augmented by a similar-sized positive contribution from FX returns, resulting in the strongest performance out of all the major EMD asset classes. In EM corporate debt, the positive overall return in the month reflected sizeable spread compression which, as in the case of hard currency sovereign bonds, far outweighed the negative impact of higher Treasury yields.
Although core rates moved higher, June was a much stronger month across the board for EMD. Sovereign spreads have tightened substantially from the wides reached at the peak of the March banking crisis, back to the tight levels last seen in February 2023. However, the absolute yield is still higher at 8.3%. Wider concerns about the economic outlook in developed markets could harm EMD relative valuations if corporate earnings weaken and spreads move to price in expectations of a recession. On the other hand, a lower Fed terminal rate and the end of US ‘growth exceptionalism’ could still be beneficial for EMs.
Softer data coming out of China means that the potential upside risk of a stronger China recovery seems less imminent. The ‘Goldilocks’ scenario for EMD would combine the current expected path for US interest rates, with the realisation of Fed Chairman Jerome Powell’s forecast for a ‘soft landing’, resulting in lower US growth and a weaker US dollar. On the other hand, the two scenarios that could lead to more risk-off conditions are upwardly revised US policy rate expectations owing to stickier US inflation and markedly increased financial stability risks.
We think the current environment calls for a high degree of selectivity, with a preference for EM credits that are less reliant on imminent market access. Likewise in the current environment, we would prefer credits with more resilient balance sheets and largely fixed-rate debt obligations, these factors should help limit their exposure to the higher cost of capital that we expect to prevail for many issuers for some time.
1 As measured by the JP Morgan EMBI Global Diversified index
2 As measured by the JP Morgan GBI-EM Global Diversified index (unhedged in US dollar terms)
3 As measured by the JP Morgan CEMBI Broad Diversified Index