Michael Cirami, director of global income and portfolio manager on Eaton Vance’s global income team, argues why real interest rates suggest value in emerging markets debt.
One of the key macro indicators of value in emerging markets debt is the real interest-rate differential with developed-market debt — the spread between EM debt and developed markets, after adjusting for anticipated inflation in respective countries. By that measure, in the wake of first-quarter volatility, we see emerging markets debt as offering a number of value opportunities.
US Treasury rates started the recent sell-off in summer 2020. The sell-off was relatively benign until mid-February 2021. Emerging markets debt was hit hard in Q1, following the sudden, sharp and volatile rise in U.S. Treasury rates in the first quarter. The JPMorgan GBI-EM Global Diversified Index, which tracks EM local-currency debt, lost 6.68% in the first quarter and the rise in rates was responsible for two-thirds of that.
Real EM rates rose only modestly during the first six weeks of the year. But they turned up sharply mid-first quarter, as investors sold off emerging markets debt and pushed up real rates, as shown in the chart below. All told, between January 5 and April 1, emerging markets real rates tacked up 107 basis points (bps) to 1.17%. Over that period, real rates in developed markets stayed the same at about negative 50 bps, pushing the real interest-rate differential to about 167 bps — the widest it has been in more than a year.
Another macro factor that can favour emerging markets debt is US inflation expectations. Since 2006, there have been six cycles of rising and falling inflation expectations, based on the 10-Year US break-even inflation rate, according to data from the St. Louis Federal Reserve Bank. In each of the rising expectations periods, the return on emerging markets debt (represented by the JPMorgan EMB (JEMB) Hard Currency/Local Currency 50-50 Index), with emerging markets debt having an average return of 13.8% over those six periods.
No exception
The most recent cycle has been no exception. As the US break-even inflation rate advanced by 173 bps between March 2020 and May 2021, emerging markets debt gained 23.51%. Of course, we don’t know if expectations will continue to rise, but with inflation dominating the news cycles and massive fiscal and monetary stimulus still in the pipeline, it’s not an unlikely scenario.
In our view, the key to capitalizing on emerging markets debt opportunities in this environment will rely heavily on understanding the economic trends within each country and the forces driving real interest-rate differentials. Many emerging markets countries have had more recent experience with elevated inflation levels. That contrasts with developed markets, where inflation is being driven — at least initially — by post-pandemic issues, like supply chain constraints and large price jumps compared with year-ago levels.
There is a wide dispersion of inflation forecasts within emerging markets countries, and some central banks are moving more aggressively to tighten policy. Russia, Brazil, Ukraine and Turkey are examples of where central banks have already hiked rates this year to help control inflation.
The real interest-rate differential between developed and emerging markets suggests emerging markets debt is now offering attractive value. But we believe capitalizing on those opportunities will require strong fundamental knowledge of each country’s economics, and how relative inflation scenarios are likely to play out in the months and years ahead.
* Michael Cirami, vice president of Eaton Vance Management, director of global income and portfolio manager on Eaton Vance’s global income team.
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