Where Next? Our Post-Recovery Outlook for Emerging-Market Debt

Emerging-market (EM) bonds got off to a strong start after a difficult 2018. Are more gains possible? We think so, and volatility sparked by increased trade tension may provide a buying opportunity for selective investors.

Last year was a tough one for emerging-market debt (EMD), which sold off broadly in an environment of rising interest rates, a strong US dollar and a global drift toward tariffs and trade protectionism.

Since then, some of the key risks that weighed on the market in 2018 have faded. The US Federal Reserve signaled that it wouldn’t hike interest rates again this year or next. And economic data indicated that China’s economy got off to a solid start in 2019 as the government ramped up stimulus support, easing fears of a sharper slowdown in the world’s second-largest economy. As a result, all EMD sectors posted gains in the first quarter, led by a nearly 7% return for dollar-denominated sovereign bonds.

But volatility returned with the recent escalation in the US-China trade war, and it’s likely to persist in the months ahead. We still think the two sides will reach a deal, but the risk of a protracted negotiation has gone up.

The good news is that there is still a lot to like in the EMD universe today, and investors may be able to take advantage of higher volatility to add EMD exposure. Investors who fear they missed the first-quarter rally may be especially well-positioned to increase exposure to attractively-priced assets.

Fundamentally Strong: Why the EM Growth Outlook Is Bright

Despite their rough ride in 2018, EM countries are still the world’s most powerful growth engine. The growth gap between EM and developed-market (DM) countries is widening. Portfolio flows into EM countries generally increase when the growth gap widens, which we expect it to do provided the US and euro area economies continue to slow to trend without contracting.

What’s more, EM countries are broadly less dependent on foreign investors for short-term financing relative to history. This makes them less vulnerable to sudden outflows. Outside of a few outlier countries, emerging markets have reduced current account deficits. That means many countries can cover a greater share of their deficits with foreign direct investment—a steadier source of financing because it tends to be longer term in nature.