Emerging market assets and developed market credit take a knock / High-yield and investment-grade credit should recover / US dollar is the main culprit for emerging market woes
Hopes were so high. At the start of 2018, the ‘Goldilocks’ environment — characterised by above-trend global economic growth, contained inflation and moderate volatility — looked set to continue, if not quite as strongly.
Importantly, in 2017, we saw better-than-expected eurozone growth and economic stimulus from the Trump administration thanks to tax cuts.
This year, however, growth momentum in the eurozone has faltered and US President Trump has escalated international tensions over trade. A global trade war looms. It is important to recognise, however, that Trump’s measures are not merely protectionist — if his objective was only to raise tariffs, he would have done so already and dispensed with any pretence of negotiations. Instead he has raised import tariffs to force America’s trading partners to lower their own, or additionally in China’s case, to change how it treats US companies that operate there.
This distinction may be irrelevant if the result of US demands is a trade war, but it does illuminate that if the current tensions are to recede, the US trade partners will need to offer concessions. Given how febrile the atmosphere has become, there is certainly no guarantee that they will.
Mid-year review: emerging market and credit assets did not outperform
The original Goldilocks scenario predicted continued outperformance of risk assets, that is, equities and credit outperforming government bonds and emerging market assets outperforming developed market assets. Midway through the year, investors have reason to feel disappointed, if not exactly misled. Emerging market assets in particular have disappointed and credit has underperformed government bonds (see exhibit 1).
Exhibit 1: Market returns, 2018 (annualised) vs. 2017
Note: Equity indices are MSCI IMI total return indices in local currency terms, except emerging markets, which are in US dollar. Fixed income index returns are in local currency except for emerging market debt. *Returns through 21 June 2018 at an annualised rate. **Emerging market debt portfolio composed of one-third US dollar sovereign debt, one-third local currency sovereign debt, and one-third US dollar corporate debt. Source: MSCI, Bloomberg, BNP Paribas Asset Management, as at 21 June 2018
For US equities, at least, returns so far this year have not been so bad and not far different from the 2017 pattern. For all the volatility the second year of Trump’s presidency has brought (the VIX has averaged 16.3 this year vs. 11.1 in 2017), equities have still outperformed government bonds and at a rate not significantly less than a year ago: the MSCI All Country World index (which includes small-cap stocks) has beaten the Bloomberg Barclays Multiverse (which includes high-yield bonds) by 6.0% (in US dollar terms, year-to-date at an annualised rate) compared to an outperformance of 15.7% in 2017. The US is again outpacing Europe and Japan.
The disappointing performance of emerging market assets is due to the strength of the US dollar as well as the rise in US interest rates. Since the beginning of February this year, the dollar has recouped all of the depreciation accumulated over the previous 13 months (see exhibit 2).
Exhibit 2: Emerging market currency index
Note: Index is the JPMorgan Emerging Markets Currency index. Source: Bloomberg, BNP Paribas Asset Management, as at 11 June 2018
This rebound has not only reduced returns for investments in local currency debt and equity for hard currency investors, it has also prompted several central banks to raise interest rates to defend their currencies, threatening the domestic growth outlook. Those who opted for US dollar-denominated securities had to contend with an 80bp increase in US Treasury yields by mid-May compared to just a 20bp gain in 2017 (for 5-year Treasury bonds, which have similar duration to the US dollar emerging market indices).
The underperformance of the developed market credit index relative to government bonds is somewhat more surprising, though in fact not quite as bad as it might at first appear. To use the US as an example (because it has more data available), we find that when government bond interest rates are rising, credit generally outperforms. High-yield credit has done so consistently and investment-grade credit more often than not (see exhibit 3).
Exhibit 3: US interest rates and credit index relative performance
*Yield-to-worst for the Bloomberg Barclays US Aggregate Treasury index. Investment-grade index is the Bloomberg Barclays US Aggregate Investment Grade Corporate index. High yield index is the Credit Suisse High Yield index II until 1995 and the Bloomberg Barclays US High Yield Corporate index thereafter. Source: Bloomberg, Credit Suisse, BNP Paribas Asset Management, as at 21 June 2018
One could explain the underperformance in the first two periods shown in the table by the higher rate of inflation at the time. The comparatively poor performance this year is likely due to far higher valuations than we have seen in the past. For example, the spread on the investment-grade index at the end of 2017 was just 93bp compared to an average since 1989 of 133bp and for high yield, it was just 343bp versus 521bp on average since 1995.
High-yield and investment-grade: set for continued outperformance
We would nonetheless anticipate continued outperformance of high-yield debt from here and a recovery in investment-grade credit. Spreads remain low, but are above the levels we saw earlier in the year. The strength of the US economic recovery suggests companies should have little trouble meeting interest payments and although there have been some disappointing growth figures over the last few months for Europe, credit conditions are still supportive. For example, the upgrade/downgrade ratio for European investment-grade debt date is at 0.9 versus a long-run average of -1.4 (according to data from Bank of America Merrill Lynch). While the current level is lower than the peak in February, it is still near the highest level since the global financial crisis began.
The outlook for emerging market assets in the short term will depend on the path of the US dollar and US interest rates, as the fundamentals remain relatively strong, if not as strong as earlier in the year: the emerging market composite PMI has dropped from 53.6 in January to an estimated 52.3 in May. The recent increases in interest rates in some countries are likely to drag further on growth.
We do foresee US interest rates continuing to rise, but not significantly from current levels. We expect the US 10-year Treasury yield to end the year at between 3.0% and 3.25% as inflation rises slightly and the term premium remains suppressed despite the US Federal Reserve’s balance sheet runoff and increased bond issuance from the US Treasury Department. US dollar emerging market sovereign spreads look attractive at these levels after having widened by 75bp from the lows early this year.
The path for German Bund yields should follow that of US Treasuries upwards as the ECB plans its exit from quantitative easing. Inflation is moving back towards the ECB’s target of 2%, though this is more visible in the headline rather than in the core rate, thanks to the fairly steady upward march in the price of oil over the last year. Of course, political developments in Italy could yet drive another rally in Bunds similar to what we saw at the end of May. While we remain cautiously optimistic that the more extreme scenarios in Italy will be avoided, the path for both core and ‘peripheral’ eurozone government bond yields is likely to be stony.
As we noted, equity market returns have been more consistent with a Goldilocks outlook and similar to those of 2017, with the exception of emerging markets. Even the poor performance of EM equities can be blamed partly on the US dollar. While the return of the MSCI Emerging Market IMI index has been -5.9% this year through 21 June in US dollar terms, it has been -2.2% in local currency terms and -2.7% in euro terms.
Nonetheless, returns across most markets have been lacklustre. For the 24 countries in the index, only six have positive USD returns year-to-date and the bulk of the positive return is from China; without China, the return would be -9.4% instead of -5.9%. The returns for China are dominated by the technology sector, however. The sector accounts for a large part of the country’s total return, as it does in the US.
Valuations: European equities draw level with US
While most valuation metrics for equities show the asset class still to be on the expensive side, one change since the beginning of the year is the disappearance of the premium that US equities had versus European equities. For the last several years, US equities (excluding the technology sector) have been trading at an above-average premium to European equities (the premium is normally about 10%). Recently, however, that premium has dropped back to the average level (see exhibit 4). While there are still reasons to be overweight European equities (primarily higher and rising interest rates in the US), the argument that European equities are notably cheaper no longer holds.
Exhibit 4: US forward P/E relative to Europe
Source: FactSet, IBES, BNP Paribas Asset Management, as at 21 June 2018
Equity market returns remain highly dependent on the technology sector, followed by energy. While we are less confident in the prospects for oil prices, technology sector revenues look like they will continue to rise faster than those in other sectors of the market.
With rising Treasury yields in the US, interest-rate sensitive sectors are likely to continue to lag, but the earnings outlook for the other parts of the market remain fairly good and valuations, while above average, are not extreme. Barring a reversal in investor sentiment (from escalating trade tensions, Italy or other causes), equity markets should continue to move upwards, albeit at a restrained pace.
Retreating central banks will lead to rising core interest rates, but with economic growth steady, the income from credit markets ought to generate outperformance. A return to sustained gains from emerging market assets will likely have to wait on a reversal in the US dollar. With the Fed still on track to raise rates several times over the next 18 months, this may happen later rather than sooner.
This article first appeared in Out of the box – quarterly investment themes from BNP Paribas Asset Management (26 June 2018)