With the Fed’s July hike likely to be the last of the cycle, we believe that EM fixed income could continue to perform well in the second half of the year, with bond markets offering highly rewarding yields, particularly in the short end of the curve. With a yield of 7.4% and a duration of 4.4 years, the spread of the JP Morgan Corporate Emerging Market Broad index needs to widen by more than 168 basis points to start losing money in a year time. Additionally, EM corporates are well positioned, benefiting from a weaker dollar and lower leverage, while EM central banks have hiked aggressively through 2022 and would be now able to support the economy if needed. However, we caution that there is a disconnect between market expectations for interest rates and high yield credit spreads. While investors expect the FED to cut rates in 2024, high yield credit spreads do not price a significant increase in default rate. To achieve a “sweet spot” scenario, the Fed would need to cut interest rates in an environment where growth is slowing, but not to a significant degree. This could be seen as a waste of the “ammunition” that the Fed may need in the event of a crisis. While it is difficult to predict which side will prevail, we believe that expecting both a lower risk-free rate and a stable credit spread is overly optimistic.
Looking ahead to the second half of the year, our focus in EM will be on high quality investments with short duration carry trades. Despite yields reaching levels not seen in nearly a decade, credit spreads are on the low side. In the case of EM corporate BB spreads, they are currently hovering around 400 basis points over swap, which is lower than their average of approximately 450 basis points over the past two decades. In an environment where the risk of recession is high and the returns on the riskiest assets are not as attractive, we prefer focusing on investment grade assets. Additionality, we favour the short end of the yield curve as we believe that the market may be disappointed by the Fed’s response in the event of a soft landing scenario. Ultimately, in an environment that offers yields not seen in decades without significant risks, there is little incentive to take on unnecessary risk.
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