In 2015, local currency sovereign debt, using the JPM GBI-EM Global Diversified Index in USD as a proxy, fell by 14.9%, while hard currency sovereign debt, represented by the JPM EMBI Global Diversified Index, generated a small gain of 1.2%.
The key drivers were the ‘managed’ economic growth slowdown in China and the strengthening of the US dollar versus most currencies. Negative sentiment, especially towards local currency debt, continued into the first couple of months of 2016, evidenced by the outflow spillover from 2015.
Although January 2016 was a challenging month for the asset class, performance throughout October remained strong. Local currency sovereign debt returned 16.1%, almost fully recovering the losses from the previous year.
The tailwind to the solid performance was a stronger fundamental situation in many emerging economies, with expectations of higher growth than in developed markets.
Dollar rebound
Additionally, after seeing the US dollar rally against almost every emerging market currency during most of 2015, valuations in local debt had become significantly more attractive. For instance, the Mexican peso depreciated by approximately 15% from January to December 2015.
Although the peso has continued on a downtrend, other currencies strengthened against the US dollar during 2016. In that vein, at least five percentage points of the index’s return through October were contributed by currency appreciation against the US dollar in most emerging markets.
Hard times
On the hard currency side, the sovereign credit spread over US treasuries, based on the JPM EMBI Global Diversified Index, fluctuated during 2015, but ended the year back where it started. Still, valuations were attractive on a relative basis compared with those in developed markets. With spreads over US treasuries tightening by at least 80 basis points, to 320, between January and October 2016, the EM hard currency sovereign debt market generated a return of 13.3% over that period.
During the month of April, the hard currency sovereign market welcomed new issuance from Argentina. The country returned to capital markets after being shunned for defaulting on more than $80bn in government debt in 2001.
Following the election of a new government and the settlement of its 14-year long battle with debtholders, the country issued approximately $16bn in US dollar-denominated debt. Managers with ability to invest in emerging markets welcomed the issuance given the relatively attractive yields on offer.
For the most part, the 2016 rally in the asset class was smooth. Although within the period discussed, May was a challenging month, especially for local currency debt. The May hiccup saw that part of the market lose 5.4% as investors digested the possibility of a Fed rate hike in the summer. In line with this, fund flows reversed but only temporarily. In fact, May was the only month of net outflows from March to October 2016, according to Morningstar data.
