Country focus comes to the fore in emerging markets

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It’s been a great year for emerging markets (EM). Through the third quarter, the major EM debt indexes were up sharply, as a lot of things have come together for the sector.

There were fundamental improvements in a number of EM countries, although by no means all of them. And valuations were compelling.

From a macro perspective, the dovish tilt by the European Central Bank (ECB) and the U.S. Federal Reserve (Fed) provided a tail wind. Investors poured $56 billion into EM debt funds through September 26, compared with $18.7 billion in 2018, which also supported the sector.

In this context, the Emerging Markets Debt Team at Eaton Vance, a global investment manager, notes: “Quite literally, we believe that there’s a world of opportunity in the EM debt space for investors who are willing to look actively for the best opportunities. Frequently, such opportunities are absent or have minimal weightings in the major benchmarks.

“The third quarter highlighted the importance of a fundamental aspect of our approach: country selection. While some countries — like Argentina, Lebanon and Zambia — had their assets come under pressure, there were many others — like Ukraine — that performed well.

“This approach requires a significant commitment of resources that few have the time or inclination to pursue. That’s one reason why so many asset managers have EM debt strategies that are based on the benchmarks, either by tracking them passively or managing allocations very closely to them.

The rally cooled a bit in the third quarter, as poor performance in Argentina helped put a damper on the EM sector. Widening spreads hurt external debt — as represented by the J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified — and EM corporate bonds — as represented by the J.P. Morgan Corporate Emerging Markets Bond Index (CEMBI) Broad Diversified. Despite falling yields, foreign exchange was a drag on local markets — as represented by the J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified.

“Both the EMBI and the CEMBI managed to eke out small gains in the third quarter, as they were helped by a non-EM factor: the continued decline in U.S. Treasury rates. Both the EMBI and CEMBI are U.S. dollar (USD)-denominated, and their issues trade at a spread over the U.S. Treasury rate.”

Four factor valuations appear attractive

“The pause in the rally has reinforced our broadly bullish view on the sector, as valuations appear attractive in the four EM debt factors: exchange rates, real yields in local rate markets, and sovereign and corporate spreads relative to U.S. Treasuries. We tend to approach the markets cautiously, with a more bearish tilt, so it’s very unusual for us to favour overweighting all four factors.

“ For example, real yields in local rate markets have been on an overall downward trend for the past decade, as many EM central banks have had success in reducing inflation. We believe that trend will continue in a number of countries,” notes the Eaton Vance team.

Source of all data: Eaton Vance as of October 17, 2019.

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