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Fixed income: Is it time to pivot toward emerging markets? – Expert Investment Views: Invesco Blog

The longer-term growth outlook for the global economy continues to improve.  Most recently, the news that a number of vaccines are proving effective at preventing COVID-19 has bolstered the case for a strong year of growth in 2021.  Given these developments, Invesco Fixed Income is looking at opportunities in emerging markets (EM).  EM has been held back by COVID-19, limited policy flexibility and weak capital flows.  As these factors change, EM has room to move higher, in our view, and we favor a pivot from developed markets. 

The macro view: Supportive policy and tight valuations

Better treatment protocols and better understanding of how to prevent the spread of COVID-19 mean that lockdowns and the associated collapse in growth are unlikely in the near future.  Instead, we believe targeted approaches to restrain the spread in hot spots, such as bars and large gatherings, can be implemented with less impact on growth.

To be sure, the recent pickup in hospitalizations and fatalities related to the most recent wave of infection will likely slow growth somewhat and may cause a slight decline in activity in the fourth quarter of this year.  This will likely contribute to uncertainty and market volatility in the quarter, but does not impact the longer-term prospects for growth or the basic underpinnings of the market, in our view.

There is a similar story around monetary and fiscal policy.  Policymakers have been extraordinarily effective in avoiding a credit crisis during the COVID-19 shutdown.  Monetary policy and fiscal policy worked in concert to ensure that credit flowed where needed in the economy, and support was provided to individuals and companies most impacted by the sharp shutdown. 

Expectations for policy in the near term have become less certain, however.  The US Federal Reserve (Fed) has continued to buy US Treasuries and mortgage-backed securities, but has not committed to any longer-term quantitative easing (QE) plan.  The European Central Bank (ECB) will likely increase the Pandemic Emergency Purchase Program (PEPP), but any large new easing is unlikely.  Fiscal support has stalled, as it has been caught up in the political process in the US and Europe, and politicians seem to have lost some of the urgency.  Our expectations are for further fiscal support, although it is unlikely to be as much as originally expected.

Short-term uncertainty around growth and policy will undoubtably contribute to some near-term volatility in markets but, in the medium-term, we continue to see sound foundations. The sheer amount of monetary and fiscal policy already put in the system will likely continue to support the economy and markets.  Monetary aggregates and lending across the US and Europe have grown strongly, indicating that conditions are very supportive of growth.  Income replacement means that, in aggregate, households are in good shape, unlike in a typical recession.  Indeed, US household net worth reached a new high in the third quarter, one quarter after the bottom of the recession. This is supporting spending in non-COVID-19-impacted sectors, with the booming housing market a prime example.  The arrival of a vaccine and the opening of COVID-19-impacted sectors will likely boost the economy further.

A key headwind for markets is valuations.  Both equity and credit markets have recovered much or all of their crisis underperformance.  The overall level of rates is low, and negative real yields in the developed market government bond markets are a major headwind for fixed income investors.  Despite the solid medium-term backdrop, Invesco Fixed Income believes valuation will prove a headwind for the developed credit and equity markets.

Valuations are very tight across the board

Source: Macrobond, US 10-year real yield is the yield on US 10-year inflation indexed securities, Bloomberg Barclays US Aggregate Bond Index Yield to Worst, Bloomberg Barclays US Corporate High Yield 2% Issuer Capped Index Yield To Worst. Data from Dec. 31, 2019, to Nov. 19, 2020.

Looking for opportunities in EM

This brings us to the potential opportunities in EM.  As mentioned earlier, EM has been held back by COVID-19, limited policy flexibility and weak capital flows.  As these factors change, EM has room to move higher, in our view. 

We expect the US dollar to broadly decline in response to continued easy monetary conditions and the likely continued decline in real yields in the US Treasury market.  A declining US dollar should ease EM financial conditions and provide support to EM.  Asia, and particularly China, which is ahead in managing the spread of COVID-19, looks particularly attractive in our view.  The Chinese bond market is a large, liquid market that provides significant yield pickup versus the US and Europe.  Judging by balance of payments performance, we view EM currencies as arguably cheap and potentially well-supported in the medium term.

The US dollar has room to decline

Source: Macrobond, US Dollar Nominal Broad Index, data from Jan. 1, 2001, to Oct. 1, 2020.

During the first stages of this recovery, fixed income investors were rewarded for investing in assets directly supported by the developed market central banks, and particularly the Fed.  As the global economy moves to a more sustained recovery, supported by a vaccine, and the developed markets keep very easy financial conditions in place, we favor a pivot.  Valuations in developed market fixed income no longer provide much upside, in our view.  We favor looking for more compelling returns further afield.

Important information

Blog header image: Alessio Lin / Unsplash

All investing involves risk, including the risk of loss.

Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

The Bloomberg Barclays US Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.

The Bloomberg Barclays US Corporate High Yield 2% Issuer Capped Index is an unmanaged index that covers US corporate, fixed-rate, noninvestment-grade debt with at least one year to maturity and $150 million in par outstanding.

The US Dollar Nominal Broad Index is a weighted average of the foreign exchange value of the US dollar against the currencies of a broad group of major US trading partners as calculated by the US Federal Reserve.

Yield to worst is the lowest potential yield an investor can receive on a bond without the issuer actually defaulting.

The opinions referenced above are those of the author as of Dec. 8, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

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