- Many emerging debt markets have become structurally less vulnerable in terms of fiscal health, private sector liabilities, external obligations, and political stability.
- The aggregate difference in political risks between emerging and developed markets has narrowed.
- Higher interest rates in developed markets, another downturn in the prices of oil and other commodities, and protectionist trade policies under the Trump administration are potential risks for emerging markets debt in 2017.
- Going into 2017, we broadly favor U.S. dollar-denominated emerging markets sovereign and corporate bonds over locally denominated debt because of the risk of further weakness in emerging markets currencies versus the U.S. dollar.
Emerging markets debt generated strong returns through much of 2016, outperforming most fixed income sectors as oil prices stabilized above their lows and ultralow or negative yields on high-quality developed markets debt pushed investors into higheryielding sectors. While these conditions may not last through 2017, we believe that emerging markets bonds remain more attractive than the sovereign debt of developed countries. Emerging markets have become structurally less vulnerable in terms of fiscal health, private sector liabilities, external obligations, and political stability.
Most emerging market countries have meaningfully improved their fiscal situations by exercising more budgetary discipline than in the past. On average, public debt as a percentage of gross domestic product is significantly higher in the G7 advanced economies than in emerging markets. The private sector liabilities of corporate borrowers in emerging markets also represent a less significant vulnerability, with 85% of emerging markets corporate leverage now held in the country of issuance.1 In the past, a common weakness of emerging markets companies and countries was the amount of leverage held by foreigners.
1 Sources: T. Rowe Price, J.P. Morgan, Bank of America, Fitch, and Bank for International Settlements. As of December 31, 2015.
External funding pressures from current account deficits, which were a major vulnerability of emerging economies in the recent past, have also receded. The average emerging market now is running only a slight current account deficit. Most developing countries have also made great strides in bringing inflation under control, thanks largely to a shift toward independent central banks with policy mandates to target price stability. Runaway consumer prices plagued many emerging countries for years, but recent inflation rates have been only a minor blip compared with the out-of-control spikes seen in the 1990s. With inflation receding, some emerging markets central banks now have more room to cut interest rates to stimulate growth.
While political risk has increased in many developed markets—as demonstrated by the UK’s surprising vote to leave the European Union and Donald Trump’s victory in the U.S. presidential election—political risk in emerging countries has been broadly trending downward. Although political uncertainty is still generally higher in the emerging markets than in the developed world, the difference has narrowed. The 2017 calendar of major elections and other political events in emerging markets is lighter than it was in 2016, limiting the number of occasions that could serve as catalysts for positive or negative change.
Emerging market countries that can implement structural reforms to position their economies for growth are most likely to offer the best long-term investment opportunities going forward, in our view. Heading into 2017, a number of the countries that appear best positioned for reforms are concentrated in Latin America. Under new President Michel Temer, Brazil has begun to enact positive fiscal reforms aimed at controlling government spending. Argentina’s president, Mauricio Macri, settled a dispute with the country’s holdout creditors in 2016, and we anticipate that he will continue to make investor-friendly reforms. Outside Latin America, India’s Prime Minister Narendra Modi should be able to continue to make reforms that position the country’s economy for growth. Modi’s recent “de-monetization” move to take certain largedenomination currency notes out of circulation to combat the country’s underground economy and tax evasion was a bold change that should bring long-term benefits despite some near-term turmoil. Additionally, we think that many observers and investors underappreciate the potential for further reforms in China as the country evolves from an export-driven economy to one based primarily on domestic consumption.
While China’s economic transition is creating opportunities for structural reform, it also presents a potential risk to emerging markets as a whole. If China’s government were to fail to engineer an economic “soft landing” as the country moves toward a more balanced but slower rate of growth, it could have profound negative effects around the world. However, we believe this risk will be mitigated in 2017 by the fact that China’s Communist Party will hold its Party Congress, which takes place every five years, in October to select its top government officials. Beijing will be strongly motivated to keep its economy from slowing sharply in advance of this key political event.
In our view, the three most significant risks facing emerging markets debt in 2017 are the possibility of a further rise in yields in developed markets, the potential for another downturn in oil prices, and a possible push by the incoming Trump administration to implement restrictive U.S. trade policies. Yields on high-quality sovereign debt from developed markets increased meaningfully after the U.S. presidential election, and further increases would eliminate part of the yield advantage that helped emerging markets bonds post strong returns in 2016.
Oil prices that leveled off in the USD $45 to $50 per barrel range generally were supportive for emerging markets bonds in 2016, but another large move downward could pressure the asset class. Finally, the uncertainties surrounding the policies of the incoming Trump administration are a major wild card. If the administration acts on its protectionist campaign rhetoric, emerging economies such as Mexico and China could suffer.
The potential risks outlined above would weigh most heavily on emerging markets currencies versus the U.S. dollar. Given that the more limited structural economic vulnerabilities of emerging markets countries now allow them to handle the consequences of currency depreciation, bonds denominated in local currencies are our least favored emerging markets debt sector. Within the asset class, we believe sovereign bonds denominated in U.S. dollars appear best positioned for relative outperformance in 2017, followed by dollar-denominated emerging markets corporate debt.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of January 2017 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance cannot guarantee future results. All investments involve risk. All charts and tables are shown for illustrative purposes only.
T. Rowe Price Investment Services, Inc., Distributor.