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Summer Dreams, Ripped at the Seams

For those in the northern hemisphere, it’s been a volatile summer for emerging market bonds. The asset class has swung between gains and losses amid concerns about rising interest rates, high inflation, slowing growth and the Russia-Ukraine conflict. Then in late-August, Federal Reserve Chairman Jerome Powell’s speech on sustained higher interest rates rattled global markets, halting a rally in risk assets.

Summer Lovin’, Happened So Fast

Spreads on emerging market sovereign bonds widened about 150 basis points from early June to mid-July. The moves in the spread sent the JP Morgan EMBI-Global Diversified Index down about 22% on the year. The index then rallied to recapture some of its performance on the back of lower inflation prints in the US, before losing steam at the end of August. Markets were looking for signs of optimism during a year of higher interest rates, soaring energy and food prices and tighter monetary policy. Hope arrived when US inflation eased to 8.5% YoY in July, down from 9.1% a month earlier. Sovereign spreads tightened from 594 basis points (bps) in mid-July—a level last tested in March 2020 and December 2008—to 490 bps by mid-August. At the same time, the yield on the 10-year US Treasury note retreated to 2.6% at the beginning of the month from 3.1% in early July. By the end of August, however, sovereign spreads widened to 501 bps and the 10-year Treasury note rose to 3.13%.

Summer Fling, Don’t Mean a Thing

We felt the optimism was premature given that US inflation was still high at 8.5% YoY in July. Eighteen months ago, in February 2021, inflation was 1.77% in the US and 0.9% in the euro region, respectively. With Brent trading at more than $90 a barrel for almost all of 2022, persistent supply chain disruptions, the ongoing war between Ukraine and Russia and unfolding energy crisis in Europe still in its early phases, we remain cautious and do not believe markets are in the clear just yet.

Opportunistic investors who pivoted into emerging markets bonds via the iShares JPMorgan USD Emerging Markets Bond ETF sent the ETF’s NAV premium to 2.04% in early August from a discount of -0.87% in June. This is the highest premium since September 2013 and April 2020. This signaled investors—at that time—paid a premium of more than 2% to buy the ETF. Capital flows into the ETF helped narrow spreads on EM bonds earlier in the month.

It Got Colder, That’s Where It Ends

Powell appears to have stalled the credit rally in emerging market bonds after his speech at the Fed’s Jackson Hole conference on August 26. Global equity markets sold off, the yield of the 10-year US Treasury advanced, and emerging market bond yields crept higher. 

Powell said the US central bank was likely to keep lifting interest rates and leave them elevated to curb inflation even if this led to a sustained period of “below-trend” growth. The Fed increased interest rates by 75 bps in July, the fourth consecutive rise since March. The move brought the benchmark rate to a range between 2.25% and 2.5%. “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance,” Powell said. “Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.”

The US labor market cooled slightly in August as employers hired fewer workers. Still, we believe the labor market remains strong and job growth has surpassed its pre-pandemic level. In our view, it is very likely that interest rates will continue to trend higher and not come down quickly any time soon.

 

DISCLOSURES

iShares J.P. Morgan USD Emerging Markets Bond ETF is an exchange-traded fund incorporated in the USA. The ETF seeks investment results that correspond to the price and yield of the JP Morgan Emerging Markets Bond Index. Artisan Partners is not affiliated with iShares and this material is not an offering of any investment product.

The J.P. Morgan (JPM) EMB Hard Currency/Local Currency 50-50 is an unmanaged, blended index consisting of 50% JPM Government Bond Index-Emerging Market Global Diversified (GBIEMGD), an index of local-currency bonds with maturities of more than one year issued by EM governments; 25% JPM Emerging Markets Bond Index-Global Diversified (EMBIGD), an index of USD-denominated bonds with maturities of more than one year issued by EM governments; and 25% JPM Corporate Emerging Market Bond Index-Broad Diversified (CEMBIBD), an index of USD-denominated EM corporate bonds. The index is unmanaged; includes net reinvested dividends; does not reflect fees or expenses; and is not available for direct investment.

Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The Index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright 2022, J.P. Morgan Chase & Co. All rights reserved.

Credit spread the difference between the quoted rates of return on two different investments, usually of different credit qualities but similar maturities.