Macro factors remain strong for EM debt after 1Q21 sell-off

Boston – Emerging markets debt (EM debt) stumbled out of the gates in 2021, producing negative returns across the asset class during the first quarter. We came into the new year expecting that the macro backdrop would be broadly supportive of the asset class, but the backup in real rates in the U.S. undermined this view, for the time being.

The rate backup led to an extremely volatile and, at times, somewhat disorderly environment, which proved too much for EM debt, particularly local rates and currencies. Fundamentals continued to improve broadly along with prospects for the global economy and generally higher commodity prices. But these net positives were easily eclipsed by the negative macro environment —the dominant factor for most EM debt investors. (See table below.)

• EM local-currency debt was hit by a double whammy. In many countries, real rates rose even further than in the U.S., depressing prices. EM currencies were also hit notably by the broad, strong U.S. dollar environment, and the sector lost 6.7%.
• Dollar-denominated, hard-currency debt had sovereign spreads tighten to U.S. Treasurys, but the rise in U.S. rates overwhelmed that, resulting in a negative 4.5% return.
• Corporate EM debt held its own, as tightening sovereign spreads gave it a sizable boost. But it was offset by rising rates, and the sector had a small loss for the quarter.

The backup in US rates drove losses in EM debt in 1Q21

Despite the sell-off, inflows into EM debt remained robust, with approximately $29 billion during the quarter, continuing to provide strong technical support for the asset class amid the global search for yield. The new-issuance market remained wide open, maintaining broad market access for countries across the credit quality spectrum.

Looking ahead

• We don’t believe the absolute level of U.S. Treasury yields is problematic for EM debt. The biggest issue in the first quarter for EM debt was the rapid, sharp increase in rates. Yields across developed markets remain low and, combined with ballooning deficits in the U.S., the U.S dollar is likely to resume weakening.
• While COVID-19 remains the dominant macro factor for markets and individuals, many EM countries have learned to live with it. The vaccine is a positive development, even though the timing of distribution to many EM countries is still a question.
• Oil and commodities, more broadly, continued their rally from the end of 2020 and have improved the economic dynamics in many countries.
• The potential for crossover buyers into EMD, along with broad interest in the higher yields available in the asset class, will continue to provide support.
• While the EM debt outlook remains rosy, we will see more defaults and a reminder of the differentiation that exists across the universe.

Bottom line: The first quarter sell-off increased the yield advantage offered by EM debt compared with developed markets, while the macro picture remains broadly positive for the sector. With proper due diligence and attention to country-specific risk, we believe EM debt deserves careful consideration from investors.