After two years of stellar performance, 2018 was a challenging year for Emerging Market Debt (EMD), with all sub-segments posting negative returns: EM Corporates (-2.9%), EM Hard Currencies Sovereigns (-6.5%), EM Local Currencies (-8.3%) and. EM Currencies (-9.6%).
The long list of headwinds (interest-rate differentials with the US, stronger US dollar, trade war, investor ouflows, …) from 2018 may not be repeated in 2019 and we are, therefore, cautiously optimistic on our EMD outlook for next year.
- We expect the US economy to continue expanding in the first half of the year but to slow down in the second half as the effects of the fiscal stimulus wane and trade tariffs start hurting the US economy.
- The Fed is likely to continue its tightening policy.
- The US dollar is likely to reverse some of its 2018 gains as US growth divergence versus the rest of the world fades.
- Eurozone growth will stabilize or at least its differential with US growth might not deteriorate further. Risks to this view are mostly political – Brexit resolution by March, Italian medium-term fiscal plans, ECB presidential transition in 1Q, European parliamentary elections in May.
- The China growth slowdown will continue, ending up at just over 6% in 2019, versus around 6.5% for 2018. If the United States slaps a 25% customs tariff on all imports from China, $(504bn in 2017), that will cut China growth by around 1%. For the time being, however, we have the Buenos Aires truce. In addition, the Chinese government will not hesitate, if need be, to implement further fiscally supportive measures.
- Commodity prices, including oil, will stabilize around current levels and stage a 0-10% recovery in 2019 on the back of demand support from Chinese fiscal stimulus and the re-establishment of supply constraints.
- The US administration-driven trade tensions are difficult to forecast in the absence of a long-term target or exit strategy but are still likely to decline after the sharp escalation in 2018.
- In this precarious environment, EM fundamentals remain broadly stable. EM growth is stabilizing around its 2018 level, with a larger dispersion between CEE and Asia, which is slowing down, and Latam, which is recovering on the margin. EM inflation remains subdued, on the back of output gaps and growth headwinds. EM debt sustainability metrics do not signal solvency issues in the near term. EM debt levels have deteriorated since the global financial crisis but the average EM public debt of 51% of GDP is still materially lower than the 100% of the GDP counterpart for DM. Total EM private debt is high: around 113% of GDP but, excluding China, the number drops to a more manageable 76% of GDP. China’s high level of private-sector debt is more of a medium-term issue that will not be resolved in 2019.
There are numerous risks to the view – the main ones centred around our US/Chinese growth, US rates and trade tension outlook – that we will continue to follow closely.
The accumulation of headwinds to EMD in 2018 pushed Hard Currency and Local Currency risk premia to attractive levels. We believe that, given our moderately constructive outlook, Hard Currency and Local Currency valuations offer much better entry points into EMD Hard Currencies and Local Currencies now than they did in late 2017, and technicals are supportive. We expect mid-single-digit returns for both EMD Hard Currencies and Local Currencies on a one-year horizon.