It has been an eventful year so far in emerging markets. Following the “Taper Tantrum” of 2013 and the sell-off that emanated from China, oil markets and anticipation of the first post-crisis rate hike by the Federal Reserve in 2015, we saw strong fundamentals drive a sustained recovery through 2016 – 17.
A lot of that positive sentiment has evaporated during 2018. But the very magnitude of the correction, against what are still broadly supportive fundamentals, suggests it may be easy for investors to miss a potential recovery—one that could be sharp. Strong nerves could prove valuable over the coming months.
The year got off to a rocky start as U.S. Treasury yields began to rise. While this did not hurt local currency bond returns, or spread returns in hard currency bonds, it did detract from total returns in hard currency. Local currency bonds were hit in May and June due to the strengthening U.S. dollar and a general tightening of financial conditions.
July offered some respite, but it turned out to be the calm before the August storm: Hard currency bonds ended the month down almost 2% and local currency shed 6%, leaving it down 15% from the previous peak. While investment-grade names came out relatively unscathed, troubles in Argentina and Turkey led a general sell-off in high-yielding issuers amid tighter financial conditions.
A Substantial Market Event
Fifteen percent sounds big, and this has been a substantial market event. Compared with the Taper Tantrum correction of 2013, this year has seen similar or even larger adjustments in currencies and spreads despite a much stronger starting position in terms of fundamentals and valuation.
For instance, hard currency spreads, at 370 basis points over U.S. Treasuries, are currently at the peak level reached back in June 2013—albeit still shy of the 2016 peak reached after the energy slump. The widening of hard currency spreads versus U.S. high yield bond spreads has been even more striking, with hard currency spreads surpassing those of U.S. high yield for the first time since 2005—and remember, more than half of the hard currency market is rated investment grade nowadays.
The 15% drawdown in local currency markets, which includes the impacts of foreign exchange and rates, ranks among the largest sell-offs since the inception of the benchmark JPMorgan Government Bond Index-Emerging Markets Indices (GBI-EM) in 2003. Now neck-and-neck with the Taper Tantrum, we have to go to the 2014 – 15 commodity crunch and the financial crisis itself to find bigger drawdowns.
Valuations and Fundamentals Align for a Potential Recovery
From a historical perspective, we have often seen stronger returns following more pronounced sell-offs in emerging markets, with significant recoveries often occurring over a one- to three-month horizon. Following the eight previous drawdowns in the GBI-EM that were greater than 10%, on average the index had recovered close to half of its losses within three months.
In our view, valuations and fundamentals—outside of weaker funding situations such as Argentina and Turkey—are starting to align, and could suggest a recovery may be on the horizon. To some extent, market positioning is also beginning to add some technical support.
Sources of further volatility are, of course, easy to identify: Some Russian issuers may be subject to international sanctions; there is still uncertainty over Turkey’s willingness to tighten monetary policy further; trade rhetoric remains heated and could threaten emerging Europe and China; the dollar could continue to strengthen on the back of Fed tightening; and October brings difficult elections in Brazil. Without these uncertainties the sell-off would not have been so steep in the first place.
That said, we still believe the overall case for a recovery in emerging markets debt over the next few months appears strong. And we would note that, while asset allocators may see the downside brewing and be timely in reducing allocations to emerging markets ahead of a sell-off, they often are not as timely in reallocating back to emerging markets ahead of any subsequent, and often substantial, rebounds.
In Case You Missed It
- Euro Zone Purchasing Managers' Index: +0.0 to 54.6 in August
- ISM Manufacturing Index: +3.2 to 61.3 in August
- ISM Non-Manufacturing Index: +2.8 to 5.85 in August
- U.S. Employment Report: Nonfarm payrolls increased 201,000 and the unemployment rate remained unchanged at 3.9% in August
- Euro Zone 2Q 2018 GDP: +2.1% annualized rate
What to Watch For
- Wednesday, 9/12:
- U.S. Producer Price Index
- Thursday, 9/13:
- U.S. Consumer Price Index
- European Central Bank Policy Meeting
- Friday, 9/14:
- U.S. Retail Sales
Statistics on the Current State of the Market – as of September 7, 2018
|S&P 500 Index||-1.0%||-1.0%||8.9%|
|Russell 1000 Index||-1.0%||-1.0%||8.9%|
|Russell 1000 Growth Index||-1.6%||-1.6%||14.6%|
|Russell 1000 Value Index||-0.5%||-0.5%||3.2%|
|Russell 2000 Index||-1.6%||-1.6%||12.5%|
|MSCI World Index||-1.7%||-1.7%||3.5%|
|MSCI EAFE Index||-2.8%||-2.8%||-4.7%|
|MSCI Emerging Markets Index||-3.1%||-3.1%||-9.8%|
|STOXX Europe 600||-2.6%||-2.6%||-5.1%|
|FTSE 100 Index||-2.0%||-2.0%||-2.1%|
|CSI 300 Index||-1.6%||-1.6%||-16.9%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||-0.1%||-0.1%||0.2%|
|Citigroup 10-Year Treasury Index||-0.7%||-0.7%||-3.0%|
|Bloomberg Barclays Municipal Bond Index||-0.3%||-0.3%||0.0%|
|Bloomberg Barclays US Aggregate Bond Index||-0.4%||-0.4%||-1.4%|
|Bloomberg Barclays Global Aggregate Index||-0.4%||-0.4%||-1.9%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.1%||0.1%||3.4%|
|ICE BofA Merrill Lynch U.S. High Yield Index||-0.1%||-0.1%||1.8%|
|ICE BofA Merrill Lynch Global High Yield Index||-0.2%||-0.2%||-0.5%|
|JP Morgan EMBI Global Diversified Index||-0.3%||-0.3%||-4.8%|
|JP Morgan GBI-EM Global Diversified Index||-1.0%||-1.0%||-11.4%|
|U.S. Dollar per British Pounds||-0.4%||-0.4%||-4.3%|
|U.S. Dollar per Euro||-0.4%||-0.4%||-3.5%|
|U.S. Dollar per Japanese Yen||-0.2%||-0.2%||1.4%|
|Real & Alternative Assets|
|Alerian MLP Index||0.0%||0.0%||7.5%|
|FTSE EPRA/NAREIT North America Index||-1.2%||-1.2%||3.8%|
|FTSE EPRA/NAREIT Global Index||-1.9%||-1.9%||-0.4%|
|Bloomberg Commodity Index||-1.3%||-1.3%||-5.2%|
|Gold (NYM $/ozt) Continuous Future||-0.5%||-0.5%||-8.3%|
|Crude Oil (NYM $/bbl) Continuous Future||-2.9%||-2.9%||12.1%|
Source: FactSet, Neuberger Berman.