The first quarter proved challenging for EM debt, mainly due to soaring US Treasury yields and a bounce in the USD, which forced less committed investors to sell. Market conditions in Q2 have so far looked more benign as the USD and Treasury yields have drifted lower. Investor appetite for risk assets seems undimmed and this more favourable backdrop for EM debt, coupled with the relatively high yields on offer, may see investors returning to the asset class.
Q1 2021 was a turbulent period for emerging market debt (EMD). The asset class suffered from the pincer movement of rising COVID cases, which hit EMs and dented confidence in local assets, and a rebounding USD, driven by higher US Treasury yields. These factors put downward pressure on local currencies and EM bonds, driving total returns negative (see Figure 1). After eight months of recovering from the March 2020 crisis, this renewed weakness was a blow to investors with flow data suggesting meaningful outflows in Q1 2021 (see the Q2 2021 Bond Compass ).
Source: Bloomberg Finance L.P., as of 31 March 2021. Past performance is not a guarantee of future results.
The flow data also indicates that holdings of EMD remain relatively high, which suggests investors have not yet deserted the asset class but have trimmed positions. Retaining an allocation to EMD looks sensible given the diversification benefits it offers, but also because several of the Q1 headwinds seem to be abating.
Source: Bloomberg Finance L.P., as of 28 April 2021. EM local currency weekly returns over the past 12 months are derived from the Bloomberg Barclays EM Local Currency Liquid Index.
There are risks. EM economies have suffered terribly from COVID as the lack of access to vaccines and logistical problems in administering them have seen infections surge. The 20% allocation in the Bloomberg Barclays EM Local Currency Liquid Index to China and South Korea, where cases have been low, provides some stability – but there are no guarantees. Even in places such as Chile, where a widespread vaccine program had been deployed, infection rates have risen again. These factors will weigh on EM growth in 2021 but may also encourage central banks to keep policy looser for longer, despite increasing inflation pressures.
In summary, Q1 proved challenging for EMD, mainly due to soaring US Treasury yields and a bounce in the USD, which forced less committed investors to sell. Market conditions in Q2 have so far looked far more benign as the USD and Treasury yields have drifted lower. Investor appetite for risk assets seems undimmed and this more favourable backdrop for EMD, coupled with the relatively high yields on offer, may see investors returning to the asset class.
1The USD is estimated by State Street Global Markets to be 5.7% overvalued relative to the basket of currencies that make up the Bloomberg Barclays Local Currency Index, as of 31 March 2021.
2For instance equities are at, or close to their highs and spreads for higher risk bonds such as High Yield are at the tight end of their historical range.
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