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Broad EM debt rally cools, but select opportunities remain

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      By Emerging Markets Debt TeamEaton Vance Management

      Boston - The third quarter saw the broad rally in emerging markets (EM) continue through July and August, albeit at a slower rate, followed by retreat in September. COVID-19 remains the macro factor dominating markets. Early in the quarter, the rally gained from signs of continued declines in the spread of the virus, along with improving growth and ongoing easy monetary and fiscal policy around the world. However, second pandemic waves and uncertainty surrounding the upcoming U.S. presidential election weighed on the latter part of the period.

      The three main EM debt indexes experienced gains during the quarter (see chart below), although local-currency debt was just barely positive, advancing 0.61%. Gains in carry and the weakening dollar (as reflected in the U.S. dollar/euro exchange rate) were largely offset by losses in rates and foreign exchange (FX). Dollar-denominated sovereign and corporate debt gained 2.32% and 2.75%, respectively, driven mostly by sovereign credit spread tightening with respect to U.S. Treasurys.

      Net investor inflows to the sector were steady all quarter, reaching nearly $16 billion, and providing ongoing support for the asset class. The new-issuance market remained active with bonds being issued across the credit quality spectrum. Debt levels are high and continue to build, but issuance activity was met with strong demand.

      Sovereign and corporate EM debt had strong performance in 3Q20

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      Looking ahead

      Looking ahead to the fourth quarter, COVID-19 remains the dominant factor, both at the macro level and for individual countries. Perhaps not surprisingly, countries that are well-managed are generally handling the pandemic relatively well, while those that are not are struggling.

      Emerging markets should have a tail wind from the low rates maintained by developed-market G3 monetary policies, along with likely weakness of the U.S. dollar, which should most notably support local-market debt. We are entering a period of rotation from hard currency to local currency. Flows into local assets over recent weeks have picked up and local currencies are at their lows for the year - two factors that are making local-currency assets uniquely attractive now. In contrast, oil prices are likely to be a headwind for many EM oil exporters, and we are seeing many of the most distressed markets in this group.

      With increasing debt levels and slow or negative absolute growth, debt sustainability should remain a concern for EM. Zambia appears to be the next likely default, while Angola, Sri Lanka and others continue to struggle. While South Africa's default is not an imminent threat, it cannot be ruled out over the course of the next few years.

      Bottom line: We entered the quarter with a broadly neutral view of EM debt, while perceiving select opportunities; as we look to the last quarter of the year, that view largely holds. FX looks broadly attractive, but beggar-thy-neighbor FX policies among EM countries remain a concern. It is an environment in which professional due diligence and selectivity remain more important than ever for EM investing.