Emerging-market bonds delivered strong returns last year, and we think the sector has more potential in 2018. But global economic and geopolitical risks abound, making it more important than ever for investors to be selective.
Emerging-market debt (EMD) got off to a rocky start in 2017 for fear that rising US interest rates and a stronger dollar would draw money out of the sector and put pressure on emerging-market (EM) government and corporate balance sheets. But investors who stayed the course did well. Through November, major indices for EM government and corporate bonds—both US-dollar and local-currency denominated—returned anywhere from 7.5% to nearly 13%.
Why has the EMD sector been so resilient? Part of the answer has to do with the health of the global economy. After nearly a decade of subpar growth, developed-market countries are finally starting to gain traction. This is good news for the developing world, because stronger growth in the US and other advanced economies tends to boost economic activity elsewhere.
In 2018, though, investors will have to exercise caution. EM fundamentals remain strong and EMD valuations broadly attractive. But macroeconomic and geopolitical risks are growing, and the global environment has become less certain. The Federal Reserve could disrupt markets by tightening US monetary policy more aggressively than expected. China’s economy could slow further, putting pressure on commodity prices.
This is why it’s essential to stay active and take a highly selective and tactical approach in order to build portfolios that can deliver long-term results.
Why It Pays to Be Choosy
The good news is that critical reforms and stronger economic fundamentals have reduced many developing countries’ vulnerability to external shocks and sudden portfolio outflows. They’ve done this by bringing inflation under control, reducing current account deficits and embracing centrist, fiscally responsible economic policies. All of this should provide EMD with a cushion that it did not have just a few years ago.
Even so, investors should be selective when it comes to their EM exposure. Country and sector selection matter, because political and economic risk varies across the developing world.