Markets began reacting to the potential economic impact of the coronavirus during the week of February 18, and we could see further volatility in the coming weeks—but we believe changes in emerging markets debt (EMD) spreads present a clear buying opportunity. Below we discuss our outlook and likely investment implications.
Having been previously insulated from the impact of the virus, spreads on sovereign EMD, as represented by the JP Morgan Emerging Markets Bond Index (EMBI) Global Diversified, widened by nearly 70 basis points (bps) to 373 bps from February 18 to 28.
At the same time, corporate EMD, represented by the JP Morgan Corporate Emerging Markets Bond Index (CEMBI) Diversified, widened more than 60 bps to 297 bps versus U.S. Treasuries.
The driving forces behind the speed of the move were twofold. During the first week of the sell-off, when commodities and equities were hit hard, there was only a gradual widening, with the spread widening by 6 bps for the JP Morgan EMBI Global Diversified and by 3 bps for the JP Morgan CEMBI Diversified.
Fear took over last week (but) market reactions to previous epidemics have historically been short lived.
Last week, however, fear took over, and we ended the week at levels not seen in the market since May 2019 for sovereigns and October 2019 for corporates.
To put this move in context, it was the largest weekly sell-off in spreads over the past 10 years, and has almost eradicated the spread compression of 2019, as illustrated below.
We have quickly shifted from an environment in which investors are seeking to buy dips to one where markets cannot find a bid—and in this environment investors are naturally wondering if EMD presents a buying opportunity.
Although it is extremely difficult to make accurate predictions about how long the coronavirus outbreak will last, how far it will spread, and its short-term impact on EMD and the economy, we can take some comfort from history.
Market reaction to previous epidemics have historically been short-lived. Using the S&P 500 Index as a barometer for risk appetite, both 6- and 12-month returns have ordinarily been positive following the first occurrence of previous global viruses.
In sovereign EMD, we observe that the recent bout of spread widening is already larger than it was in previous global epidemics such as SARS, Ebola, and H1NI (bird flu). While each virus had a different level of infectiousness, fatality rate, and endurance, the market response to each has tended to follow a very similar cycle of denial, fear, panic, and then recovery.
If the impact of the coronavirus outbreak lasts longer than anticipated, we are likely to see a policy response.
Regarding coronavirus, since containment measures were successfully implemented in mainland China in early February, the number of confirmed cases has steadily fallen. This is encouraging.
Although it is frightening to read about cases outside of China escalating in more than 70 countries, we believe that in the coming weeks global containment measures will likely have a similarly meaningful impact.
We should see a greater understanding of the illness and a more draconian set of lockdown measures. This should help ensure that a gradual slowdown in the number of reported cases and very little structural, permanent damage to the global economy, as with previous epidemics.
If the impact of the coronavirus outbreak lasts longer than anticipated, we will likely see a policy response consisting of a combination of more accommodative monetary policy, bank support, fiscal expansion, and financial assistance from international financial institutions.
The International Monetary Fund (IMF) has already said it is ready to offer grants and debt relief to poorer countries affected by the virus. World central banks have spoken about a collective response to lower rates and improve global liquidity conditions, and the U.S. Federal Reserve has already cut interest rates by 50 bps.
We do not, however, rule out further market volatility in the coming weeks. A series of negative headlines regarding the spread of the disease and its short-term effects on the economy seem inevitable. Meanwhile, it is human nature to seek profit in buoyant markets. That is why we say we believe changes in spreads present a buying opportunity for investors with a medium-term outlook.
Investment Implications—Sovereign EMD
The sell-off in high-yield, commodity-sensitive markets has been particularly pronounced over the past week on both an absolute and relative basis, and the disconnect in valuations between high-yield and investment-grade markets is notable.
Additionally, indiscriminate selling in very thin liquidity may offer some excellent entry points in specific names that we believe now offer value on a medium-term basis, so we believe selectively adding risk now makes sense.
In the CEEMEA region (which includes Central and Eastern Europe, the Middle East, and Africa), we like oil-levered economies in key Middle Eastern nations. Bahrain has been improving fiscally and has strong regional support; it looks particularly attractive if the Organization of the Petroleum Exporting Countries (OPEC) supports oil prices. Oman is now trading with significant rating downgrades and could be an improving fiscal story if the new Sultan delivers on his early rhetoric to decentralize power. And Uzbekistan is a relatively illiquid market with a strong reform story and attractive spreads.
We also like markets where negative domestic news has coincided with changes in global risk sentiment to create a toxic selling environment unwarranted by facts. Turkey fits here, as we believe the situation with Russia and Syria is unlikely to escalate to the point the market is currently pricing. Similarly, in spite of the recent sell-off in Ukraine’s debt, we believe that the positives around Ukraine are still in place.
In Latin America, vulnerable oil credits such as Mexico and Ecuador were hit disproportionately hard on fears that lower global growth will lead to lower commodity prices. But primary products remain an important driver of dollar revenues for the region.
In Asia, while we recognize Mongolia’s dependence on the Chinese economy, we see increased value after the recent sell-off given its relatively strong fiscal position and light investor positioning.
Indiscriminate selling in very thin liquidity may offer some excellent entry points, so we believe selectively adding risk now makes sense.
Investment Implications—Corporate EMD
While changes in corporate spreads have been less dramatic, we also see opportunities here.
For instance, Brazilian banks’ senior bonds have underperformed the JP Morgan CEMBI Diversified, but we like the fundamentals of the Brazilian banking sector and believe it should remain resilient even if external weakness weighs on domestic activity, thanks to its healthy capitalization, limited foreign currency exposure, and manageable commodity exposure.
Also in Brazil, the protein sector seems unduly punished. African swine fever, reduced cattle availability, and Australian weather conditions support pricing, as does long-term demand. While the sector has de-levered, we see these trends continuing.
Commodity producers have been among the worst hit in the coronavirus sell-off, but we expect oil and gas companies to be more resilient than industrial metal producers. In metals, weak demand and uninterrupted supply have led to inventory buildups, and current prices anticipate Chinese stimulus. We see stronger likelihood of a quick rebound in oil pricing and thus spread given supply disruptions and expectations of accelerated cuts from OPEC and its allies.
Why Our Outlook Is Positive
There are many reasons—in addition to the historically short-term effect of previous viral epidemics on EMD—that we believe now may be a good entry point for investors with a medium-term outlook.
Valuations are attractive. The current spread of 370 bps for the JP Morgan EMBI Global Diversified has not been seen since August of 2019 and is more than 40 bps greater than the average 10-year spread.
Technicals are strong and flows remain positive. The asset class oversold on thin liquidity, which lowered prices—a temporary phenomenon that has occurred periodically over the past 20 years. Additionally, sovereign EMD has attracted more than $11 billion of inflows this year, and EMD buyers tend to be sticky.
Global liquidity conditions should continue to drive asset prices. Global central banks have provided a positive tailwind to EMD, and support is likely to widen rather than narrow.
Fundamentals remain supportive. Aside from a handful of poorly managed countries that are already priced for default, the potential for further restructuring is limited. Sensitivity to U.S. Treasury yields also supports EMD, and any real or perceived economic disruption caused by coronavirus could lead to further repricing of risk-free assets, which benefits the investment-grade portion of the benchmark (which an experienced manager can exploit to generate alpha in the medium term).
For details about our 2020 outlook for EMD, please keep an eye out for a series of blog posts, or read our paper.
Daniel Wood and Luis Olguin, CFA, are portfolio managers on William Blair’s emerging markets debt (EMD) team. Other members of William Blair’s EMD team contributed to this post.
Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks. These risks may be enhanced in emerging markets. Investing in the bond market is subject to certain risks including market, interest rate, issuer, credit, and inflation risk. Rising interest rates generally cause bond prices to fall. Sovereign debt securities are subject to the risk that an entity may delay or refuse to pay interest or principal on its sovereign debt because of cash flow problems, insufficient foreign reserves, or political or other considerations. 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. Diversification does not ensure against loss. Any investment or strategy mentioned herein may not be suitable for every investor. Past performance is not indicative of future results.
Zero-volatility spread (Z-spread) is the constant spread that makes the price of a security equal to the present value of its cash flows when added to the yield at each point on the benchmark spot curve where cash flow is received. The J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI) is a market-capitalization-weighted index consisting of U.S.-dollar-denominated corporate bonds issued by emerging markets entities. The J.P. Morgan Corporate Emerging Markets Bond Index Diversified is a uniquely weighted version of the CEMBI designed to result in more balanced weightings for countries included in the index. The J.P. Morgan Emerging Markets Bond Index Global Diversified (EMBIGD) tracks the total return of U.S.-dollar-denominated debt instruments issued by sovereign and quasi-sovereign entities. Index information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The indices are used with permission. The indices may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright 2020, JPMorgan Chase & Co. All rights reserved.