Dhawan: The Coronavirus outbreak has hit Emerging Markets, traditionally a higher-return, higher-risk asset class, which has suffered as investors sought safe-haven assets.
Some emerging markets, like Russia and Mexico, are also big oil exporters, so they’ve been damaged by the recent collapse in oil prices. This has been a lot for emerging markets to take all at once. As a result, EM currencies have plunged against the dollar, whilst the premium that investors demand to hold EM assets has soared.
The shock, of course, is not an emerging market-centric one, but a global one, and we are seeing a global effort, from central banks and policymakers around the world, adding new, record amounts of monetary and fiscal stimulus to try to avert a deep and prolonged recession. Like in the US and Europe, emerging markets monetary and fiscal authorities have also injected liquidity into local markets and passed stimulus packages as they try to mitigate the shock.
Recent sales of emerging market bonds has been indiscriminate, impacting not only the at-risk issuers that have little policy flexibility but also higher-quality issuers with strong balance -sheets.
At one point in March, the market had become overwhelmed by one-way selling pressure – roughly $40 billion rushed out of emerging market bond markets in the span of a few weeks, which is an unprecedented number.
These dislocations have led to losses, but have also lifted the risk premiums and yields to rarely seen levels before. And this opens the door to opportunities in our view.
Spreads are at near all-time wides on dollar-denominated bonds and potentially compensate investors for a level of default that has never before occurred.
We believe repair will take time. EM is an “outer perimeter” asset and the system must repair itself from the inside out, first in the US Treasury market, then in the AAA-rated US mortgage market and then in the high-quality US corporate market.
Moreover, the uncertainty is still paramount and the effects of the lock-down may be longer-term than what we initially thought. Some emerging markets issuers will default – and low-quality oil-exporters are particularly vulnerable.
Therefore, over the near future, we favor dollar-denominated, high quality, emerging markets sovereign and corporate issuers, especially those with strong balance sheets. Most of the issuers operate with low leverage and excess cash reserves, which are held by central banks, sovereign wealth funds and so-called “rainy day funds”, precisely because they have navigated numerous past crises.
In emerging markets it is interesting to think about the longer-term, once the dust settles on this current episode. Local EM markets are one of the few places left that still offer “old normal”
levels of yields, ranging from between 4-8% on mostly investment-grade rated bonds. This stands in sharp contrast to yields in Europe and Japan but now also in the U.S.
As volatility continues to subside, we think investors can move out of the risk spectrum towards local markets where currencies look cheap in our opinion and local yields still remain elevated compared to developed market yields.
Above everything, as ever, EM investing is all about differentiation across countries and issuers and about having a long-term view.
Past performance is not a guarantee or a reliable indicator of future results.
All investments contain risk and may lose value. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. 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. Sovereign securities are generally backed by the issuing government. Diversification does not ensure against loss.
The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
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