It has been almost three months since we published our EM corporate credit asset class outlook for 2021. What has happened since then? Have any of our views significantly changed? Quickly approaching the end of the first quarter, we take this opportunity to review some of our calls and refresh our outlook.
Many developments have taken place broadly as expected, although some materialized significantly faster than anticipated. The interest rate move has been sharp, hurting total returns, but as we outline below, we see only limited potential for additional steepening over the near term. Credit spreads have tightened meaningfully year to date and are in some pockets approaching fair value, leaving less room for much further tightening. However, we continue to emphasize that the core strengths of this asset class – attractive risk compensation, strong fundamentals, relatively low duration – remain unchanged, if not strengthened, going into the second quarter of 2021.
- The sharp rise in interest rates – a potential challenge we were closely monitoring in our December outlook – came faster and more aggressively than most had thought. Expansive fiscal and monetary stimulus in conjunction with the economic situation around the pandemic easing has raised concerns around accelerating inflation. Having said that, real rates have remained firmly in negative territory and nominal rates at historically low levels, despite the recent steepening of the yield curve. While a first glance might suggest that a further steepening is possible, two points should be kept in mind:
First, as emphasized by Fed chairman Jerome Powell, the labor market remains heavily strained. Employment continues to be strongly depressed, and uncertainty surrounding the speed of recovery remains high. The major central banks are still dovish and have in some cases already hinted at potential reactions in case of excessive sell-offs. Second, yield curves in other major currencies remain significantly flatter, and cross-currency hedge costs, based on short-term interest rates, comparatively low. Currency-hedged US Treasury yields for foreign investors have therefore improved significantly, to some extent acting as a balancing force. Ultimately, we continue to closely monitor rates and any potential volatility. - Contrary to interest rates, risk sentiment has overall remained broadly positive. Mostly withstanding individual bouts of volatility, EM corporate spreads have tightened significantly throughout all regions since December. Credit returns are positive for all rating segments, although the lower-rated segment is leading the way, benefitting from a supportive financing environment for high yield issuers and strong commodity prices.
Figure 1: JPM CEMBI BD IG (lhs) and JPM CEMBI BD (rhs) – Spreads since December 1, 2020
Source: JP Morgan, February 2021
- The overall technical environment also remains particularly robust. Investment inflows demonstrate the anticipated strong demand for EM corporates’ attractive carry and comparatively low duration, which pairs well with the expected modest net new issuance. Since yields remain at low levels even after the recent steepening, we expect cross-over demand for EM corporates to remain solid for the foreseeable future.
On the issuance side, net new issuance is expected to remain manageable with most of the net financing coming out of Asia, where the local investor base remains a supportive factor. The other regions, particularly Eastern Europe and Latin America, continue to see a decrease in issuance. Additionally, ESG issuance within EM corporates has materially increased this year, which we see as a positive development for the asset class. However, we do see differentiation within ESG structures and prefer sustainability-linked bonds with KPI targets versus plain green bonds. - In terms of valuations, we continue to find EM high yield credit particularly attractive, and see potential for further tightening. The improving economic environment and the generally low duration in this space make for a compelling combination in the inflationary environment. Conversely, we regard valuations as richer in EM investment grade (IG) relative to EM high yield, as 12 out of 23 countries are already tighter in terms of spreads compared to year-end 2019. Within investment grade, we prefer higher spread bonds, which can also, to some extent, provide a cushion against rising interest rates. At the same time, we are cautious on higher duration bonds, and currently see limited value in certain very high-quality countries. With that said, we would like to note the relative attractiveness of EM IG corporate spreads on a duration-matched basis versus other asset classes. The spread pick-up between EM corporates IG and US IG is still wider than pre-Covid levels, while the duration gap is at an all-time high. Even though EM corporates have always had a significantly lower duration compared to EM IG sovereigns and US IG credit, this duration gap has widened materially over the past three years.
Figure 2: Modified duration EM corporates (JPM CEMBI BD IG), EM sovereign (JPM EMBIG) and US investment grade since December 2015
Source: JP Morgan, December 2020
Figure 3: CEMBI BD IG performance versus EMBIG IG, US IG since December 2020
Source: JP Morgan, February 2021
- Anticipated as one of the major themes in 2021, commodities have rallied across the board. Oil and petrochemical products, metals such as copper and iron ore, as well as agricultural commodities such as soybeans and corn, have similarly gained in double-digit percentage terms. As we have noted, the importance of commodities for many EM companies, and even entire economies, has been acting as a rising tide that has lifted all boats, supporting macro-level and company-specific fundamentals in a large part of our universe. Although, in some cases, supply bottlenecks have contributed to the price increases, we continue to see a favorable environment for most commodities.
- As fourth-quarter results are published and corporate management provide updates, we observe that fundamentals in our investment universe continue to improve. The second half of the year has turned out to be better than expected for many companies. Unlike their developed market (DM) peers, EM corporates have managed to avoid a meaningful increase in gross debt, thus limiting increases in leverage. As revenues and margins improve within the economic normalization, fundamentals should continue to improve towards their pre-Covid levels.
Figure 4: Net Leverage of investment grade rated EM, US, and European corporates since 2009
Source: JP Morgan, December 2020
Figure 5: Net Leverage of high yield rated EM, US, and European corporates since 2009
Source: JP Morgan, December 2020
Some developments mentioned in our previous outlook have not had a major impact on our investment universe (yet). While there has been a sovereign downgrade in Panama, the market reaction has been relatively orderly. Chinese onshore defaults continue to make headlines, but the government’s capacity to deliver fiscal and monetary stimulus, if necessary, remains high, while economic data in China continues to be mostly solid. US-Sino relations have clearly become less volatile already under the Biden administration, although neither an improvement nor a deterioration is evident yet, and we continue to see a tense relationship as the strategic rivalry is likely to remain. Other geopolitical issues in the limelight include US and EU sanctions on Russia, but the impact in our universe has been relatively muted so far.