A quick look at a timely topic of interest - with a brief review of why it could matter to investors.

Chart of the Week

September 1, 2014

Emerging markets: calmer for now
Emerging market currency volatility, sovereign & corporate bond yields

chart

Source: Bloomberg, as of 8/26/14. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The bottom line:

  • After spiking briefly, emerging market (EM) bond yields are notably lower than a year ago. The same is true for EM currency volatility – which tends to reflect many of the same investor perceptions about individual EM countries' economic prospects.
  • How should investors view these recent declines? Do they reflect better economic outlooks for specific EM countries or reduced uncertainty about the path of global interest rates? Arguably, a bit of both – suggesting that low volatility in the sector could persist for some time.
  • But that calm could also dissipate quickly; emerging markets can be highly sensitive to world events. There's certainly no shortage of simmering geo-political risks (Russia/Ukraine, China/Japan, ISIS, Gaza, Argentina and more); concerns about growth rates in the developed world (which continue to have ripple effects on their EM trading partners);  or potential policy errors (Europe, China, US) that could lead to unexpected developments and temporary spikes in EM volatility.
  • In addition, longer-term fundamentals could be a cause for concern. The pace of reforms undertaken to support long-term competitiveness varies among EM nations and some countries are currently growing faster than others. As a result, specific currencies and securities could experience heightened volatility even if the overall environment remains benign.
  • All of these are reasons to consider the susceptibility of individual countries and securities to capital flows that could result from quick shifts in investor sentiment. Flexibility is the key to taking advantage of potential pricing anomalies by making timely, tactical adjustments to duration, sector allocation and currency exposure.

The chart:

  • The chart shows the JP Morgan Emerging Market Volatility Index, and the yields of the JPMorgan EMBI Global Diversified Sovereign and JPMorgan CEMBI Diversified Broad Composite indexes.
  • All three have been in a trend of general decline over the past five years, with several spikes of varying magnitude along the way—generally related to concerns about global growth and the direction of interest rates/monetary policy.
  • The JPM Emerging Market Volatility Index hit an all-time low in June 2014, while EM sovereign and corporate yields, while notably lower over the past year, were still a little higher than they were in late 2012 and early 2013.

Context & Perspective:

  • The latest legs – up, then down – in currency volatility and EM bond yields were part of a longer trend toward lower volatility and yields, reflecting in part the slow global economic recovery, low inflationary pressures and very accommodative major central bank policies of recent years.
  • In addition, more fundamental developments are also at play. Many EM countries have more investor-friendly economic characteristics today than they did a couple of decades ago, including lower debt as a percentage of GDP, better growth prospects, lower inflation rates, and improved fiscal and trade balances.
  • As a result, valuations for EM debt instruments have improved significantly vs. similar US debt – in short, investors are not demanding as much additional yield to invest in EM debt today as they once did. This lower yield premium could be read as a perceived decrease in the riskiness of EM bonds as a group.
  • For example, at the end of 2001, the JPMorgan EMBI Global Diversified Sovereign Index yielded over 11% and the yield of the JPMorgan CEMBI Diversified Broad Composite Index yielded over 9%. Compared to the 5.6% yield of the Barclays US Aggregate Index, there's a difference – a spread – of over 540 basis points and 450 basis points respectively.
  • Fast forward to today – yields are about 5.1% for both EM indexes, and the spread to the Barclays Aggregate yield of 2.3% has dropped to 280 basis points.
  • But even after that decline, EM debt may still represent  an ample source of opportunity for fixed income investors willing to take on the additional risk of the asset class.
  • Today's relatively low EM yields (reflecting high prices), tight spreads and low volatility could be a signal of investor optimism about current economic conditions and prospects for the near-term future, either at the country or company level.
  • But even if the emerging world's dependence on commodities and other exports to developed markets is decreasing, their economic prospects are far from untethered from the developed world. The impact: the pace of growth in China (soft-landing?), Europe (growth or recession?) and the United States (faster or slower?) over the next several quarters will have a bearing on the market levels and stability in EM debt.
  • One specific developed market – the US – could have another type of direct impact on EM. If the pace of growth in the US were to accelerate more than expected, the US Federal Reserve might raise rates sooner, or more aggressively, than currently anticipated. In that event, volatility in EM markets could suddenly reappear, as it did last year when the Fed first mentioned, then backpedaled, then finally implemented its tapering program.
  • Of course, the expansion of any of the now simmering regional conflicts, or a financially systemic contagion sparked by a nation's debt default or a major bank failure lurks in the background of today's markets. Any one of these – or any combination – could potentially create a less favorable global business environment by disrupting capital flows, decreasing liquidity and ultimately affecting the creditworthiness of nations and corporations. In that event, the markets will doubtless let investors know whether – and how much – to worry.

Definitions:

Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.

A spread is the difference in yield between two different types of fixed income securities.

The JPMorgan EM Volatility index is an index of implied EM currency volatility calculated based on currency 3-month at-the-money-forward volumes, which are combined with a set of fixed weights to produce the daily result. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges.

The JPMorgan Emerging Markets Bond Index (EMBI) Global Diversified Sovereign Index tracks U.S. dollar denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities.

The JPMorgan Corporate Emerging Market Bond Index (CEMBI) Broad Composite Index is a global, liquid corporate emerging markets benchmark that tracks U.S.-denominated corporate bonds issued by emerging markets entities.

Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

A basis point is one one-hundredth (1/100, or 0.01) of one percent.

The Barclays U.S. Aggregate Bond Index is an unmanaged index of U.S. investment-grade fixed-income securities.

Developed markets refers to countries that have sound, well-established economies and are therefore thought to offer safer, more stable investment opportunities than developing markets.
Tapering refers to the Fed's announced approach to reduce the pace of its monthly asset purchases gradually instead of ending the purchases all at once.


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Past performance is not a guarantee of future results.

All investments involve risk, including possible loss of principal.

Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges.

Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.

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Yields represent past performance and there is no guarantee they will continue to be paid.

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