IN BRIEF - JP Morgan Asset Management

IN BRIEF - JP Morgan Asset Management

2020: From margin to mainstream
Emerging market debt strategy
Q1 2020

                                     IN BRIEF
                                     • We expect another positive year for emerging market debt in 2020, with base case
                                       expectations of about 8% returns for emerging market hard currency, and 11% for
                                       emerging market local currency. With currencies presenting a near pure beta play, we
                                       believe that hard currency debt may have a marginal performance edge on a risk-adjusted
                                     • Our investment views incorporate a low-growth base case scenario for the developed world
                                       and an acceleration in emerging market growth from 4.1% in 2019 to 4.3% in 2020.
                                       Although Chinese growth is set to continue to decelerate, recoveries elsewhere should
                                       boost emerging market economic activity. We therefore expect the emerging market
                                       growth premium over the developed world to widen to 2.9% in 2020, the highest level
                                       since 2016.
                                     • Compared to last quarter we now expect closer relative returns, supporting the case for a
                                       more balanced asset allocation going forward.
                                     • We think local currency debt is attractively valued and expect increasing investor flows
                                       following recent strong performance. We see room to add more anchored emerging market
                                       currencies within our more flexible strategies. Within the hard currency world, we continue
                                       to find value in high yield, especially within the BB complex.
                                     • Weaker corporate earnings and a higher default rate mean we are entering 2020 with a
                                       more negative outlook for emerging market corporate debt but balance sheets remain
                                       strong, particularly in investment grade.

                                 IN 2020
                                 We expect another positive year for emerging market debt in 2020, with base case
                                 expectations of roughly 8% returns for emerging market hard currency, and 11% for
                                 emerging market local currency. With currencies presenting a near pure beta play, we believe
                                 that hard currency emerging market debt could offer a marginal performance edge on a risk-
AUTHOR                           adjusted basis.
                                 Central to unlocking these expected returns is the continued validity of our low growth base
                                 case scenario for the developed world. We believe emerging market growth can accelerate
                                 from 4.1% in 2019 to 4.3% in 2020. While we expect a continued growth deceleration in
                                 China, recoveries elsewhere—for example Brazil, Indonesia, Turkey and Russia—should
                                 contribute to improving growth.

Pierre-Yves Bareau
Head of Emerging Market Debt,    Forecasts are not a reliable indicator of future performance.
J.P. Morgan Asset Management     All data is sourced by J.P. Morgan Asset Management as of December 2019 unless otherwise stated.

We expect the emerging market growth premium over the                              Against this backdrop we expect emerging market debt to take
developed world to widen to 2.9% in 2020, the highest level                        some leadership from external drivers. A divided US government
since 2016 (Exhibit 1). We believe the US economy will avoid a                     is unlikely to deliver large shifts in policy and it is possible that
recession in 2020, and that the European economy should see                        the associated uncertainty is negative for growth. With weak
an improvement in export demand. While leading indicators                          growth, low inflation and a plethora of sources of uncertainty in
point to a stabilisation in European growth, we have not yet                       play, we continue to expect developed market core rates to
seen an increase in activity. Much of our growth expectations in                   remain low. These negative factors in the developed world may
2020 rely on a Chinese recovery, which appears to be increasing                    become a technical positive for emerging market debt: with G4
in probability. Recovery feeds from better sentiment, so a                         balance sheets expanding at an annual rate of USD 1.2 trillion,
resolution to ongoing trade tensions will be crucial if emerging                   emerging market debt is likely to present a strategic source of
market and global growth is to gain momentum.                                      real yield for investors.
                                                                                   While we expect core financial conditions in the world’s
We expect the difference between emerging market and
developed market GDP to widen slightly                                             developed economies to remain easy, late cycle credit and
                                                                                   earnings dynamics provide a risk to this thesis. Accordingly, we
                                                                                   think the US dollar may shift to a weakening bias, with
            6      Diff     DM       EM
                                                                                   additional drivers of monetary stance shifting to a more
                                                                                   expansionary footing. Taken together, these factors underpin
            5                                                     JPMAM 2020F
                                                                    EM 4.4%yoy
                                                                                   our belief that emerging market local currency debt could
                                                                                   potentially perform well in 2020.
%q/q saar

                                                                  EM-DM alpha
            3                                                         2.9%yoy
                                                                                   CHINA: NEXT STEPS IN THE TRADE WAR
                                                                                   Our base case expectation for the Chinese economy in 2020 is
                                                                                   5.6% GDP growth, marked by an incremental recovery in the
                                                                                   second half of the year. In our view, a “phase one” trade deal
            0                                                                      with the US that removes or amends existing tariffs is possible,
                3Q14       3Q15       3Q16        3Q17     3Q18         3Q19
                                                                                   though difficult negotiations lie ahead. These could include
Source: J.P. Morgan Asset Management, J.P. Morgan, Bloomberg: data as of           intellectual property enforcement and technology transfers,
3 December 2019. Data for 2Q19 includes estimates for Argentina and Turkey.
Opinions, estimates, forecasts, projections and statements of financial market     among other areas, that may prove controversial to both sides.
trends are based on market conditions at the date of the publication, constitute
our judgment and are subject to change without notice. There can be no             We think a number of key points behind the current trade
guarantee they will be met.                                                        tensions may remain unresolved, including the Huawei 5G issue,
                                                                                   a number of “Made in China 2025” policy directives, the South
Emerging market economic growth is dependent on demand for                         China Sea and the “One Belt One Road” programme. Taken
the bloc’s exports. Over time, the composition and value-add of                    together, these points form a material risk to our thesis, given
this component has matured. Today’s increasingly sophisticated                     their capability for surprise. A further intensification of the trade
EM exports now account for a greater portion of global                             war is possible, potentially reflected in new tariffs and
manufacturing and an increasing amount of intra-emerging                           restrictions on Chinese individuals and activity. China is not
market trade. Emerging markets now enjoy a greater level of
                                                                                   defenceless, and maintains the capability to push back—up to
growth resilience in the event of a slowdown in the developed
                                                                                   and including weakening its currency. So far, the Chinese
markets, or China.
                                                                                   response has focused on stimulating domestic activity, through
Interest rate cuts from emerging market central banks have                         infrastructure investment, tax cuts for small businesses, and
helped to sustain this resilience. Easier monetary policy helped                   other incentives.
to protect growth in 2019 but many central banks now have less
                                                                                   We have factored continued trade tensions into our expectations
policy room in 2020. This leaves the emerging market world
vulnerable to a growth shock if trade wars intensify, with trade-                  for Chinese growth. We assign a 35% probability to the
sensitive currencies an acute source of risk. However, less                        completion of a phase one trade deal, which we view as positive
monetary policy flexibility means we expect to see increasing use                  for Chinese growth. Successful completion of a phase one deal
of fiscal policy. Emerging market fiscal stimulus has been led by                  raises our expectations for Chinese GDP growth to 5.6%. In our
Asian and EMEA (Europe, Middle East and Africa) countries.                         worst case scenario, to which we assign a 10% probability, trade
Inflation also remains well anchored, though dispersion is                         tensions intensify to include a 25% tariff on a further USD 265
beginning to appear, which is important as it means selectivity                    billion in Chinese imports, plus the addition of “poison pill”
will remain an important component of portfolio construction.                      measures in the fourth quarter.

2           2 0 20 : F R OM MA R G IN TO M AINS TREAM

Within our base case assumptions, we assign a 30% probability                             However, Chinese investment in technology is likely to power a
to a “Cold War” scenario where the trade war broadens to                                  recovery in the semiconductor cycle in the first quarter,
include Europe and Japan and the 25% trade tariff extends to                              eventually supporting a mid-year turn in the Asian
include all Chinese imports. In this scenario we expect Chinese                           manufacturing cycle, and finally a pickup in the industrial cycle
growth to drop to 4.2%. We think there is a 25% chance of an                              towards the close of the year. A recovery in the Asian
                                                                                          manufacturing cycle does not mean that China’s repaired the
easing or postponement of the trade war, in which we believe
                                                                                          damage from the trade war, but rather that the economy is on a
that China could grow 5.4%. On a probability-weighted basis, it
                                                                                          pathway to do so.
is possible 2020 Chinese growth slips to 4.9%, though we
acknowledge a dispersion of risk around this expectation                                  Currently, Chinese factory activity is visibly slower than that
(Exhibit 2).                                                                              seen in September 2017 (Exhibit 3), with intermediate goods
                                                                                          (for assembly) continuing to slow. Wage growth has slowed
Three scenarios for the trade war and their impacts on Chinese                            accordingly and household disposable income has fallen. A
economic growth                                                                           gradually improving global purchasing managers’ index suggests
                                                                                          that support may be forthcoming, barring another flare up in
                                                                                          the trade dispute.
Scenarios              Measures in 2020                      Growth       Prob.
                                                                                          China has responded to consumer weakness with tax cuts while
Phase 1                25% on $250bn (no Dec tariffs +       5.8%         35%
                       partial rollback of tariffs)                                       Chinese banks have been increasing credit. We expect China to
                                                                                          continue injecting stimulus into the economy, possibly increasing
Postpone               25% on $250bn + 15% on $104bn         5.4%         30%
                       (no Dec tariffs only)                                              by 8%-11% in 2020 and coinciding with a RMB 1 trillion increase
                                                                                          in local government debt raising. These actions should create
Cold War               25% on All + other measures           4.2%         35%
                                                                                          growth resilience going forward.
Source: J.P. Morgan Asset Management. Growth forecasts reflect estimates of real
economic activity. Opinions, estimates, forecasts, projections and statements of
                                                                                          Beyond the urgency in these policy decisions, China faces
financial market trends are based on market conditions at the date of the                 longer-term growth worries. The realities of China’s ageing
publication, constitute our judgment and are subject to change without notice.            population, for example, will become more visible through rising
There can be no guarantee they will be met.
                                                                                          dependency ratios in the new decade. China is looking to offset
                                                                                          the impact through the creation of an industrial and
A cooling Chinese economy will have global implications,
                                                                                          technological hub in the south east of the country. We expect
reflecting in weaker manufacturing data in both developed and
                                                                                          China to spend around USD 200 billion per year over the next 11
emerging markets. China is a major driver of the 40% of the
                                                                                          years to bring next generation infrastructure to a small core of
global industrial demand that originates in Asia, meaning that
                                                                                          cities in this region.
the trade war impacts European car manufacturers, metals
producers and commodity-related industries accordingly. While                             The composition of China’s trade accounts has also changed.
American manufacturing accounts for only 5% of exports, in                                Nearly 35% of China’s exports now go to the emerging world,
Europe the sensitivity is more elevated, as manufacturing                                 versus less than 15% that go to the US. This shift in composition
accounts for 16% of total exports.                                                        has helped the Chinese trade account and improved investor

The bounce in global industrial production is from the technology cycle; manufacturing, industrial and auto output remain weak
 7%            Machinery & equipment (11%)       Tech (7%)      Food, Textiles, Utilities (24%)            Autos (7%)   Other Manufacturing (42%)      Mining (9%)
 6%              Global IP (3m/3m ann. growth)






      Jan 15               Sep 15                May 16                 Jan 17                    Sep 17                May 18                Jan 19                 Sep 19

Source: Credit Suisse, Haver. Numbers in parentheses are % contribution to Global IP. Data as of 30 September 2019.

                                                                                                                                 J.P. MORGAN ASSE T MAN AGE ME N T            3

sentiment toward China. In the fourth quarter of 2019, China            2020 also create risk for investors, as the outcomes could alter
received nearly USD 25 billion in bond inflows, reflecting              the fundamental framework of the country. We will watch both
investor confidence in its policy and the appeal of a substantial       events closely.
rate differential. While the Chinese economy is slowing down, we
                                                                        With social security reform now passed, Brazil’s political
think Chinese government bonds will remain relatively stable.
                                                                        leadership will address a myriad of less visible reforms. If
We expect the People’s Bank of China to maintain liquidity and
                                                                        successful, we expect to see Brazil posting better fiscal and
gradually allow rates to fall, though we think they will continue
                                                                        growth projections. The challenge is that the market may look
with the policy of a rate buffer.
                                                                        prematurely for evidence of growth and thus a re-rating. Were
                                                                        progress on reforms to regress, investors could easily withdraw
EMERGING MARKET ALPHA: KEY COUNTRY VIEWS                                some of their recent enthusiasm, which could result in both a
                                                                        weakening of the currency and a material increase in local
While we expect a solid return from emerging market debt in             yields. However, we think it more likely that reforms will
2020, we think the dispersion within the asset class—and the            continue to gather momentum, and that this will reflect in a
momentum around that dispersion—will drive performance. Our             moderately stronger currency.
2020 scenarios suggest a wide range of opportunities in
emerging market currencies and local currency debt, while               South Africa and Indonesia: Potential challenges ahead
credit default swaps remain broadly expensive.
                                                                        South Africa enters the new year facing a number of challenges,
Russia and Mexico may outperform Brazil and Chile                       perhaps most notably around the budget, which is expected in
                                                                        February. Rating agencies will look for evidence of improving
In Russia, although the risk of sanctions remains, we think             fiscal discipline. Should South Africa fall short, the country’s
Russian bonds will likely stay out of scope. Russia currently           bonds will likely fall below investment grade, resulting in their
operates a twin surplus economy, which helps the outlook for            exclusion from the widely followed World Government Bond
hard and local bonds alike. In our view, the currency could             Index (WGBI). We think it likely that the central bank remains
appreciate by around 4%, especially if the central bank cuts            constrained by the fiscal policy outlook.
rates less than expected, which would create considerable value
in local bonds and could attract strong support for the market.         Indonesia enters the year in a relatively better position. In our
The imposition of sanctions against Russia could materially             view, it is likely that the country maintains the current status
weaken both the local currency and local bond prices.                   quo economically, helped by President Jokowi’s policy continuity.
                                                                        This makes local rates in Indonesia attractive. The main risk for
Although Mexican fiscal performance was one of the positive             Indonesia is that the country is sensitive to broader market
surprises of 2019, we think a US slowdown will present a rising         beta, meaning an escalation of the trade war or another
headwind. We expect to see a gradual deterioration in Mexican           negative global event could potentially shock the local economy.
fundamentals, as consumer strength is already fading and
business sentiment weakening. As a result, Mexico’s ratings are         Turkey: Looking for a cyclical upswing in 2020
at risk of being downgraded by Moody’s and S&P, both of which
already have a negative outlook. We also think the state oil            We expect Turkey to muddle through its challenges in 2020,
monopoly PEMEX is likely to have its rating downgraded in the           which should strengthen both the currency and local bond
first half of the year.                                                 prices. We see an upswing in the Turkish cyclical indicator, which
                                                                        in turn points to a recovery in economic growth, likely due to
Despite these expectations, Mexico’s risk premium appears to be         the combination of fiscal, credit and monetary impulses, which
cheap. We assign a 15% probability to a more bearish outcome,           we expect to align in 2020.
with the biggest risk being a shock to the real economy from
tariffs, downgrades, a deep recession or a large fiscal or political    Turkey’s current account is also on an improving trajectory and
shock. In light of these risks, we think it likely that Banxico         we expect it to move into surplus in the coming year. Inflation is
continues to ease rates to around the 6% level. Given the higher        also moderating. Turkey’s deteriorating public finances present a
probability of the gradual deterioration scenario, we believe           risk, albeit one that is reduced through growth and easing
Mexican local bonds continue to offer value.                            external debt issuance pressure. Hence we see some value in
                                                                        hard currency Turkish bonds.
The outlook for Chile looks more complex. We believe the most
likely scenario is that the country muddles through the current
political situation, but the risk of major changes is not negligible.
We see room for the currency to strengthen if Chile resolves its
issues, and more material weakening if it fails to do so. These
risks are reflected in local bond yields. In our view, increased
fiscal spending may smooth the path towards a new constitution
and government. The planned plebiscites in April and October

4   2 020 : F R O M MA R G IN TO M AINS TREAM

FOR QUALITY INCOME                                                          IMPROVING SPONSORSHIP, BRIGHTER OUTLOOK
Emerging market hard currency debt valuations have increased as             Local currencies look attractively valued (Exhibit 5), supported
more investors seek quality income. For managers, a paramount               by G3 central bank balance sheets that are continuing to add
concern is avoiding the drawdown that follows when countries                reserves to the system and growth expectations that are
deliver negative surprises, as hard currency debt has entered a             rebounding from a low base. Within local curves, we think
period where the market has become more judgemental and                     duration remains anchored by core rates, though individual
punishes those countries that deviate from trend.                           country allocations are in places more finely balanced.
The quality income theme has tightened the investment grade
market and is prompting investors to reach across into high                 Local currency yields look attractive
yield in search of upgrade candidates and mispriced value,
                                                                            EXHIBIT 5: REAL YIELD BY COUNTRY VERSUS FIVE-YEAR AVERAGE
which makes calling a broader beta trend more challenging. We               STANDARD DEVIATION
continue to see value in the BB arena, where more attractive                8                                                                       4
                                                                                    Real yield (LHS)    5yr Z score (RHS)
spreads may benefit from the relative tightness seen in the BBB
universe (Exhibit 4). In this market, we think credit                       6                                                                       3

differentiation continues to be crucial for successful investing,           4                                                                       2
though we caution that the Treasury call may yet again be more
                                                                            2                                                                       1
important than the spread call.
                                                                            0                                                                       0

BB spreads look attractive versus the tight BBB universe                    -2                                                                      -1

EXHIBIT 4: CHANGE IN BB TO BBB/B THREE-MONTH SPREAD                         -4                                                                      -2
                   150                                                      -6                                                                      -3
                                                      BB-BBB/B 3mo spread
                                                                            Source: J.P. Morgan Asset Management, Bloomberg, as of December 2019. Real
                                                                            yield is the 10-year bond yield minus realized CPI year-over-year.
Spread Chg (bps)


                                                                            As the market embraces expectations of a stable or softening
                                                                            dollar, investors have increasingly turned to the local currency
                                                                            space as a source of both performance and higher yielding
                                                                            duration. We think the optimal positioning for investors is
                                                                            currently to build exposure to selective duration while playing
               Jan 14      Jan 15   Jan 16   Jan 17     Jan 18    Jan 19    tactical currency beta. However, as momentum towards local
                                                                            currencies builds, we think a shift towards higher beta names—
Source: J.P. Morgan Asset Management, Bloomberg.
                                                                            for example, higher yielding local issuers—might produce higher
Increasing social tension generated substantial risk in 2019, and
                                                                            Supporting this transition is an improving level of investor
we think will continue to do so in the near future. Looking at
                                                                            engagement. While emerging market local currency bonds have
socio-economic indicators, we see youth unemployment rising
                                                                            lagged competitive asset classes in recent months, recent data
ominously in a number of countries, while corruption and
                                                                            shows a sharp pickup in flows into local currency versus peer
concentration of wealth are becoming more paramount in
                                                                            assets. We expect seasonality and 2019’s stronger performance
others. An evaluation of these factors suggests a concentration
                                                                            to trigger further flows into the asset class and support
of risk in both Middle East and Latin American countries, an
                                                                            performance early in the first quarter.
observation that we remain mindful of in our investment
strategy. We further note that the increasing prevalence of
investments based on environmental, social and governance
(ESG) factors has had a performance impact, enhancing issuers
with more positive scores. We expect the pool of ESG-aware
assets to continue to grow.

                                                                                                               J.P. MORGAN ASSE T MAN AGE ME N T         5

EMERGING MARKET CORPORATES: LATE                                     With concern on late cyclicality in sharper focus, it is not
                                                                     unreasonable to expect the market to look more closely at
CYCLICALITY, STRONG CREDIT QUALITY                                   default risk as a potential source of performance impairment. In
Of the three emerging markets asset classes, emerging market         recent years, emerging market corporates have proven
corporates show the most evidence of late cyclicality. However,      themselves good servicers, presenting a relatively low default
after several years of prudent balance sheet management, they        rate. 2019 continued this trend, with a 1.2% overall default rate.
also appear well prepared for an eventual slowdown. The              We think default rates will increase modestly in 2020 to roughly
market has rewarded these corporate performances with                2.4%, including distressed Argentina (Exhibit 7). Removing
relatively full valuations, meaning investors expect a solid         Argentina reduces our expectation to 1.7%, a level more
performance into a moderating headwind.                              consistent with recent performance.
At the aggregate level, a negative earnings trend may add            Weaker corporate earnings and a higher default rate mean we
pressure to the sector, though overall sector leverage remains       are entering 2020 with a more negative outlook for the broad
well below the 2016 peak (Exhibit 6). Emerging market                market. As such, we believe that 2020 will be a year where
corporates have also been reducing capex levels over the last few    excellence in credit selection can create value for investors. We
years, particularly in Latin America. Interestingly, emerging        also note that differentiation within emerging market corporate
market corporate debt issuer forecasts indicate that the current     debt is wide: investment grade balance sheets look solid, but the
weakness in earnings is likely to continue, while emerging market    high yield space looks more vulnerable.
equity forecasts are pricing in a rebound. It is worth noting that
                                                                     With the credit cycle maturing, we think the majority of
the two markets differ markedly in issuer composition.
                                                                     emerging market corporate sectors will report past-peak credit
In addition to corporate earnings, we see a number of factors in     fundamentals, with financials following suit over the next 12
the year ahead that may influence returns. Between 2020 and          months—a situation that would present more of a challenge if
2022, there will be a substantial increase in external bond          balance sheets in the broader emerging market corporate
maturities, dominated by Asia and EMEA, with China being a           universe were not beginning the process from a strong position.
major contributor. Within China, the bulk of these maturities        As a result, we do not see defaults disrupting the story as has
come from investment grade issuers. Within the Chinese high          happened in the past, which gives us scope for selection. While
yield space, we expect real estate borrowers to be able to           we are more bearish than consensus on earnings, we still see
access finance, as many issuers have been actively prefunding        solid credit fundamentals within the space as a whole.
2020 maturities. We expect the peak for high yield debt
                                                                     Also, while the refinancing schedule is brisk in 2020, we think
maturities in April, with some USD 7.3 billion coming due (July’s
                                                                     many corporates have moved ahead of the curve and are thus
USD 7.5 billion is a higher overall total, but the composition is
                                                                     well prepared to manage maturities over the next year. The
oriented more towards investment grade).
                                                                     major concern in the corporate space is that the improving
                                                                     macro environment is not yet strong enough to generate much
                                                                     performance, while faltering growth could expose investors to
                                                                     greater downside risk.

Leverage in the emerging markets corporate sector remains            EM corporate default rates remain low but will likely increase
well below the 2016 peak                                             slightly in 2020

                          2.2x                                                      4.3%
                                                       2.0x                                3.8%   3.8%
                                            1.8x                             3.5%

                                                                                                                       1.6%   1.5%


       2016              2017              2018       H1 2019         2011   2012   2013   2014   2015   2016   2017   2018   2019   2020E

Source: J.P. Morgan Asset Management.

6   2 0 20 : F R OM MA R G IN TO M AINS TREAM

Our base assumptions look for a continuation of the current low   Our base scenario expects another solid year for emerging
growth environment, with key drivers around trade and politics    market debt investors in 2020, though our riskier scenarios are
ranged against developed market easing. For this reason, we       more pessimistic. This argues in favour of a more balanced asset
believe that core yields will remain contained, meaning           allocation, and hence we think there is merit in rotating from
emerging market currencies are likely to appreciate due to G4     external credit and local duration into emerging market
balance sheet expansion and softening US growth.                  currencies early in the year. Valuation provides some comfort in
                                                                  external credit, though more for sovereign and BB rated bonds.
We think the emerging market growth premium will recover,
                                                                  Locally, we like duration in mid- to high- yielding countries
which is an essential component of our investment thesis. While
                                                                  where we see scope for policy easing, such as in Mexico, Peru
we think Chinese growth may slow further to 5.8% in 2020 as a
                                                                  and Russia.
result of the trade dispute, we see other emerging market
economies recovering while the developed world slows.             With core yields in European sovereign bonds remaining low, we
Emerging market accounts show no large imbalances on              think emerging market real growth and real yields will continue
aggregate, but differentiation remains key, especially as some    to look attractive, leading to a structural “mainstreaming” that
central banks have actively used policy ammunition. Therefore,    should support the asset class in the year ahead. With lower net
not all emerging markets still have room to ease, with fiscal     supply expected in 2020, we may see these flows result in
space even more limited. The increasing prevalence of social      further performance resilience.
tension, both globally and within emerging markets, may
pressure already vulnerable emerging markets, and remains a
key risk for us in 2020.

                                                                                               J.P. MORGAN ASSE T MAN AGE ME N T   7

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