Emerging market debt surges in 2016 despite rocky Q4

Eaton Vance Global Income Team

Boston - Emerging market (EM) debt had robust performance in 2016 - surpassing our expectations - but the fourth quarter was very challenging in the wake of the U.S. election.

Through most of 2016, investors flocked to the sector following a string of disappointing years that left EM debt with relatively attractive valuations and yields. All three EM debt classes exceeded or approached double-digit returns for 2016 - the best performance for the sector since 2012, as shown below.

 Following the election, with the prospect of higher U.S. rates and stronger dollar, investors again exited the sector and reversed the year's positive trend. Local sovereign debt fell 6.1%, led by the sell-off in currencies vs. the dollar, and higher interest rates (see chart below). External (dollar-denominated) debt fell 4.0%, on the back of higher U.S. rates - a good example of the U.S. duration risk embedded in external debt, but often overlooked by investors. EM corporate debt did relatively well, falling just 1.3%, thanks to its relatively lower exposure to U.S. duration. 

The EM outlook this year is mixed. On the positive side, interest rate differentials with developed countries are the widest they have been in 10 years. But country fundamentals, overall, show limited improvement, currency outlooks are varied, and EM corporate credit is richly valued, with poor compensation for the risk.

Bottom line: In 2017, we see country selection as the key to success. The impact of Trump's policies will vary, so careful analysis of EM risk factors of fundamentals, currency, rates, and corporate and sovereign spreads is likely to be rewarded.

Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging countries, these risks may be more significant. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer's ability to make principal and interest payments.