Following two consecutive years of strong returns, emerging market debt investors are likely to reap somewhat more modest gains in 2018. But EM debt returns may still exceed other global fixed income asset markets thanks to its still substantially higher yields. Strong global growth has always historically been a boon to the asset class. Fundamentals are in general improving. The dispersion in country returns in the coming year will likely be driven more by political outcomes than significantly divergent economic prospects.

Global macro drivers remain supportive

The US dollar will likely continue to be a key for this asset class. The market clearly anticipates future hikes from the Federal Reserve (Fed).

The dollar has not deviated significantly from its stable to softer trajectory, however, following the 2014-2015 stratospheric rise that heralded the beginning of the end for quantitative easing (QE). If this continues, local currency debt will likely be a top performer again in 2018.

Real interest rates (policy interest rate minus inflation) are very attractive in key countries as inflation has diminished with currencies appreciating.

We do not expect significant divergence between developed market central banks which might induce currency volatility. The European Central Bank (ECB) has chosen a significantly gradualist approach to diminishing QE which has been well telegraphed. Rate hikes by the Bank of England (BOE) and Bank of Canada (BOC) may have been one-off occurrences rather than the start of prolonged cycles.

Developed market growth seems stable as well. Latin America has benefited from stable Chinese growth and a better supply-demand dynamic in commodities. Central European growth has benefited from low rates on the continent. Emerging Asia growth has similarly prospered as Chinese and Japanese economic volatility has been low.

With that type of stable global backdrop, emerging markets have the potential to grow at about twice the rate of the developed world.

A number of large emerging countries are benefiting from historically low inflation.

The flattening of the US Treasury yield curve (a reduction in the difference between interest rates on short and long-dated Treasuries) suggests that growth, rather than inflation fears, are more prominent. Realising those fears may be contingent on the Fed becoming more aggressive in hiking rates.

With few signs of inflation rising concertedly or persistently above target that seems for now an unlikely prospect. Without a monetary surprise in developed markets or a meaningful sell-off in bond prices, emerging market dollar debt continues to offer an attractive relative level of income.

Divergences unlikely to derail all

Despite the solid economic and fundamental backdrop, some countries in EM face challenges that primarily stem from political factors. Mexico will have a presidential election, with a leftist entering the year as front-runner, and faces the renegotiation of the North American Free Trade Agreement (NAFTA).

Nevertheless, a significant policy deviation does not seem likely since corruption is the front-burner issue and asset prices have underperformed in anticipation.

South Africa and Turkey are also potential hot spots. In South Africa fiscal discipline is deteriorating and tensions within the ruling party creates significant political uncertainty. For Turkey, President Erdogan's consolidation of power and his interference with the central bank will leave assets there under pressure for some time.

Lastly, Venezuela's default as 2017 drew to a close was well anticipated. The asset price reaction was completely insulated within the country with no regional contagion.

Credit quality improving

In contrast to those trouble spots, by and large credit quality in emerging markets is on the mend. Following downgrades to multiple large countries, sovereign investment grade countries dipped to less than 50% of the index before slowly recovering to the current 51%.

Corporate creditworthiness is similarly on the rise. Much of the bond issuance going forward is likely to represent companies funding themselves at attractive rates or refinancing existing debt to further improve their balance sheets. The growth in foreign exchange reserves across the asset class throughout the past two years has been a key to the overall improvement.

The fact that both sovereigns and corporates have taken advantage of this environment to improve credit quality rather than turn profligate, augurs well for the foreseeable future.

Schroders plc published this content on 05 December 2017 and is solely responsible for the information contained herein.
Distributed by Public, unedited and unaltered, on 05 December 2017 11:36:04 UTC.

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