Headwinds buffet emerging-market debt

D. William Kohli, Michael V. Salm, and Paul D. Scanlon, CFA
Co-Heads of Fixed Income, 08/25/15

Despite the recent challenge of capital outflows, emerging-market debt (EMD) outperformed a variety of fixed-income asset types during the second quarter. But higher interest rates in developed markets — and expectations for more of the same — may continue to lead many investors to reallocate their assets away from emerging markets, which warrants caution in the months ahead.

EMD performance

Higher developed-market rates pull assets away from emerging markets

Higher interest rates can be a challenge for any fixed-income market, but rate increases in advanced economies cause particular difficulty for emerging markets. Higher rates in advanced economies attract capital from other markets in pursuit of higher yields with lower perceived risks.

That dynamic began to play out during the second quarter as the U.S. economy continued to improve and the U.S. Federal Reserve began to prepare markets for an increase in the federal funds rate. Emerging-market stocks bore the brunt of the adverse effects from the capital reallocation, though local debt, dollar-denominated debt, and currencies all experienced weakness. It’s worth noting, however, that emerging-market government debt performed better than U.S. Treasuries in the second quarter, while corporate debt wound up in positive territory.

Commodity price weakness may complicate matters

A number of emerging markets are major oil exporters, which adds another source of uncertainty as they face rising interest rates. A brief period of stability in oil prices earlier in the summer, which gave a number of commodity exporters more flexibility in making debt repayments, gave way to renewed weakness in the third quarter.

That said, throughout the current commodity price cycle, we believe that EM countries and companies have kept their credit profiles in decent shape. A useful comparison in this regard is the economic environment in the United States during the financial crisis of 2008. In the wake of the crisis, the U.S. economy slowed fairly dramatically and, in fact, still has not grown consistently since that time. But since then, the U.S. corporate sector has become much stronger in terms of building cash balances and expanding operating margins — and all of this has happened in the absence of consistently robust growth. We have observed similar dynamics with respect to EM corporate securities, and we note the resilience of many companies in this segment of EMD during the second quarter.

High yield may be the canary in the coal mine

Overall, we are cautious about the broad prospects for EMD in the near term. Another segment of the global credit market — high-yield debt — struggled near the end of the second quarter as Treasuries rose, and that may be a harbinger of difficulty for EMD. We believe that investors should be prepared for some volatility in the EMD asset class, which could be amplified by any further erosion of confidence in emerging-market fundamentals, as well as continued capital reallocation as the global interest-rate picture changes.

Read Putnam’s full Fixed-Income Outlook for Q3 2015.