SINGAPORE (Jan 10): Yields on USD emerging market debts are reaching 7% for major indices, and as emerging markets enter 2019, it is expected to recover from the negative effects of a stronger USD and outsized US growth, according to a Schroders TalkingPoint report for January.

These effects shifted liquidity away from the asset class, similar to the 2014-2016 period when the Fed first began ending quantitative easing and raising interest rates. Also much like that period, currencies have been the adjustment mechanism of choice for stressed countries.

Despite deeply negative local returns, countries for the most part avoided spending foreign exchange reserves in an attempt to stabilise the currency.

James Barrineau, head of emerging markets debt relative at Schroders, says, “Thus, when the smoke begins to clear, countries generally find that creditworthiness has not deteriorated significantly, dollar debt is not perceived to be seriously at risk of default, and a slow recovery of growth can begin. Broadly, that is where the asset class finds itself.”

Moreover, Barrineau finds prospects for dollar debt in the emerging markets very favourable.

Yields on non-investment grade debt have steepened considerably faster than those of investment grade. And as pressures on the asset class ease, historically that has reversed fairly quickly.

Even if one assumes a slower recovery for prices, Barrineau believes that yields at 8% and above on average offer investors a cushion not available in other liquid fixed income asset classes.

However, until the dollar definitively heads lower, local currency bonds as a whole will be challenged to deliver returns comparable to dollar bonds.

Currently, yields on the local currency index are now roughly flat to dollar index yields, while the historical average is about a 100 basis points (bp) yield differential for local debt.

Yields may have rose in local bonds, but they did not rise as quickly in aggregate, as many countries in Central Europe, Asia, and Latin America were not pressured to increase their interest rates.

“It will take a quite unambiguous turn in the US dollar to allow investors to benefit from sustained currency rallies across the asset class in our view,” says Barrineau.

This year, the outlook for the Fed policy should be clearer as the best of US growth (in 2Q18) is over, enhancing the probability that the asset class will outperform a rare negative year across all major dollar and local currency indices.

But if the Fed remains on its current hiking path, that may be an event beyond 2019.

“We find shorter duration non-investment grade dollar bonds attractive. The most stressed countries in emerging markets have made large strides towards fundamental stability. Although growth will be slower, it is unlikely that macroeconomic imbalances threaten a recovery in asset prices,” adds Barrineau.