Emerging-market bonds and equities have both enjoyed a strong rally this year, but there is a growing feeling that the momentum is fading.  

Tai Hui, chief market strategist for Asia at JP Morgan Asset Management, argues that EM stocks have further room to rise, notably consumer names in China, India and Indonesia.

Yet he is wary about EM debt, particularly corporate bonds, given their high valuations and high volatility. He is more comfortable with EM sovereign debt, in light of EM central banks’ accommodative monetary policy and because he sees the dollar strength approaching its limit.

But he concedes there are risks that could scupper the EM debt rally, and other market observers, such as rating agency Standard & Poor's, support this view.

Bond concerns

Hui agreed with the widespread view that EM corporate bonds were no longer cheap. Moreover, he warned that EM debt was inherently a more volatile asset class than its DM counterpart.

He added that high-yield and EM debt would not deliver much in the way of capital appreciation, but that their coupon and yields could generate sufficient income.

But EM sovereign debt remains a good bet, said Hui, given that DM government bond yields are ultra-low and EM governments have more fiscal flexibility than their DM counterparts, which are running out of options for policy easing.

He cited India as an example. The country’s central bank cut its repo policy rate by 25 basis points to 6.25% on Tuesday, a move that came earlier than markets expected.

What’s more, there is very little cushion to protect investors from DM bond volatility, noted Hui, as investors are only receiving 1.5% yield from US 10-year Treasuries and nothing – or even less – from German and Japanese government bonds.

However, he conceded there were risks for EM sovereign debt that could result in the rally unwinding. These include another round of appreciation of the dollar, which he sees as overvalued; problems emerging from China's high volume of debt; inflation risk in the US; and declining risk appetite because of political changes. 

Moreover, EM sovereigns face rising risks to their credit quality, according to S&P.

Moritz Kraemer, global chief rating officer for sovereign ratings at S&P, said: “Nine of the 20 top emerging-market sovereigns – those with the largest absolute amount of sovereign debt outstanding –have negative outlooks, indicating a possible downgrade over the next two years, against just two positive outlooks.”

S&P’s average rating on this group of sovereigns has declined by nearly one notch since the start of 2011. And yet, over the same period, cumulative EM inflows have exceeded $1.1 trillion, as yield-seeking investors flee ultra-low interest rates, noted the rating agency. The JP Morgan US dollar EM bond index gained 13% in 2015 and rising a further 21% this year as of Wednesday.

S&P now expects the Fed to raise rates in December, gradually bringing to an end the super-accommodative international financial environment from which EMs are benefiting.
 
EM equities "still cheap"

Meanwhile, Hui said that equities remained the main driver of returns globally.

This year, as of September 30, EM ex-Asia equities have returned 23.4%, followed by EM debt at 15%, global corporate high yield at 13.4% and Asia ex-Japan at 12.8%, according to JP Morgan data. 

Hui doesn't envisage an end to the EM rally any time soon, suggesting: “We are at an earlier stage of this emerging market recovery.” This is because the dollar is approaching the end of the bull market it has been in since 2011 and EMs are still cheap, he added.

The MSCI EM index was trading at a price-to-book ratio of 11.1x as of the end of September, lower than its 15-year average of 12.4x, while the MSCI Asia Pacific P/B ratio stood at 13.5x compared with its 15-year average of 14.7x.

Hui predicted a slight shift towards EMs in Asia at the expense of DMs, without giving a time frame.