EM Debt Is Safer Now

Remember when emerging-market debt investors used to fret about Federal Reserve interest-rate hikes? Apparently, they don’t care anymore, or at least not very much.

Even though it’s almost a sure thing the Fed will bump up overnight borrowing costs next week, investors are racing into these bonds. Funds focused on this debt received more than $2 billion of deposits in the past week, the second-biggest flow in 2017, according to Wells Fargo Securities analysts, Lisa Abramowicz commented for Bloomberg.

Investors are demanding the lowest amount of extra yield to own these notes relative to similarly rated US debt since 2013.

Dollar-denominated bonds of developing nations are performing better this year than US investment-grade and high-yield corporate credit.

This all comes as developing nations build up record amounts of dollar-denominated obligations. This makes them more vulnerable if the greenback strengthens—as many expect it to do as the US central bank tightens monetary policy. Meanwhile, any global economic downturn tends to disproportionately harm these nations, which rely on faster growth.

That sounds pretty bad, and it would be easy to dismiss this rally as a display of irrational exuberance, with debt buyers simply blindly searching for extra yield.

But that's too simplistic. This rally, especially in the face of a Fed rate hike, marks a pretty profound shift. These nations have changed. They’ve developed. They’re also very different from one another. With more than 80 countries included in the Bloomberg Barclays EM Hard Currency Aggregate Total Return index, it’s a more diverse universe than, say, a corporate credit index reliant only on the US or Europe or Japan.

And these smaller nations tend to be less leveraged than bigger, more established ones, which have relied heavily on non-traditional stimulus efforts that caused their debt outstanding to balloon. Meanwhile, the global economy suddenly looks more resilient than it did just a year ago, with inflation picking up and signs of sustained growth.

So while emerging-market debt isn’t immune, it seems less vulnerable than it used to be against selloffs in developed markets. There is, of course, a catch. Many of these bonds are in a vulnerable position if oil prices materially weaken.

Investors Demand

One of the cornerstones of President Donald Trump's declared policy is to negotiate better trade deals for the US with its neighbors, as well as with key trade partners in Asia.

Where does that leave trade-dependent Asia and the other emerging markets, many of which count the US among their top three trading partners? And how should investors play the emerging trend?

To tackle this question, one needs to first examine the backdrop. There are a few factors favoring EMs at the moment.

First, EM growth is accelerating relative to developed market growth for the first time since 2009, and Asia is set to remain the biggest growth driver for the global economy. Second, EM equity market valuations are more attractive than those in DMs, after years of underperformance. Third, many EMs, especially outside Asia, are emerging from recessions or sharp downturns in their equity, bond and currency markets.

Against these favorable trends, there are counterbalancing factors. Apart from the likelihood of trade frictions, the most significant risk facing Asia and EMs is rising interest rates in the US, as Trump's policies could potentially generate faster growth and higher inflation. Historically, higher US rates have tended to be a challenging environment for many EMs, given the possibility of triggering capital outflows.

However, many believe capital outflows are not inevitable. There are three factors to keep in mind.

First, many EMs—including China—have already faced significant capital outflows. This suggests that the most susceptible components may already have left. Second, the gap between the low US rates today and fairly high rates in many EMs is quite large. This may offer an additional source of support for the EMs.

Finally, US interest rates would most probably have to rise at a faster pace than what is already expected, to trigger large-scale capital outflows. Markets are arguably already looking for at least two rate hikes from the Fed this year, so an upside surprise from this baseline would likely be needed for markets to start worrying about EMs.