2019 started off strong for EM and broader risk markets, which recovered from the selloff in late 2018. We believe EM assets benefited from an improvement in external funding conditions, as data indicated a slowdown in US economic activity. This manifested in a weaker US dollar and lower core-market yields. However, concerns over global growth persisted over the quarter, leading to bouts of US dollar appreciation and weakness in EM currencies in February and early March. EM credit remained resilient, with credit spreads trading in a tight range over most of the quarter. We attribute this EM credit performance to strong demand for higher yielding fixed income assets, as core-market yields moved steadily lower. EM sovereign credit outperformed the EM fixed income complex with first quarter total returns of 7%, compared to 5.2% for EM corporate credit and 2.9% for EM local debt (in US dollar terms) over the period. (Figure 2)
Base-case scenario Q2 2019: Ascending, with turbulence
The improvement in financial conditions experienced since the first quarter provides scope, in our view, for further gains for EM assets in the second quarter. In addition to shifts toward policy accommodation by the European Central Bank (ECB), the People’s Bank of China (PBoC) and most notably the US Federal Reserve (Fed), we expect EM assets to be supported by steady global growth convergence, with US growth slowing and the rest of the world stabilizing. These outcomes would likely manifest in a weaker US dollar, which should strengthen EM currencies and lead to compression in EM credit risk spreads and local bond yields. In fact, this backdrop is expected to lend support to EM assets over the balance of the year.
However, we anticipate higher volatility in the second quarter. We expect global growth to slow over the first half of the year, albeit towards trend, and clearer signs of stabilization to show in the second half. This outcome likely limits scope for material improvement in underlying EM macro fundamentals and creditworthiness. In the near term, economic data may prove to be volatile, adding uncertainty to the global growth outlook.
As of this writing, trade negotiations between China and the US are ongoing and could be an additional source of uncertainty. Additionally, the currently heavy election period across EM may raise policy uncertainty in a number of key countries, even if the election results themselves do not throw up big surprises. Therefore, we believe EM valuations will be bounded to the upside over the quarter. Underlying fundamental improvement may remain elusive, making asset performance increasingly reliant on demand for higher-yielding assets, thus limiting the scope for an immediate decline of EM credit risk premia.