Boston - Emerging markets debt (EM debt) suffered significant losses, along with most capital market sectors, as a result of the dual shocks of the COVID-19 outbreak and plunging oil prices. With rare exceptions, the financial and economic stress from COVID-19 was felt universally across all EM risk factors and countries. Financial aid packages from central banks and fiscal authorities globally helped stem the decline toward the end of the quarter.
Local-currency sovereign debt was hit the hardest, falling 15.22%, as measured by the JP Morgan Government Bond Index - Emerging Markets (GBI-EM), driven mostly by losses in foreign exchange (FX). The only factor for EM local debt with a modest positive contribution was carry, at 1.38% (see chart below).
External sovereign (dollar-denominated) debt was down 13.38%, as measured by the JP Morgan Emerging Market Bond Index - Global Diversified (EMBI). But the total return number masked the extent of the sell-off in "hard-currency" EM debt because losses were partially offset by a 10.45% positive contribution from US Treasurys. As a standalone factor, sovereign spread widening accounted for 21.78% of the loss.
EM corporate debt index declined by 10.17%, as measured by the JP Morgan Corporate Emerging Market Bond Index (CEMBI). As with the EMBI, decline in the CEMBI would have been significantly worse, at -16.95%, without the positive contribution of 6.78% from US Treasurys.
Double-digit losses were mitigated only by US Treasury performance
Many emerging markets do not have the fiscal buffers and institutional capacity to effectively deal with a crisis of this nature, and debt distress for the most vulnerable countries will likely pick up materially. IMF support is beginning to roll out, but these programs offer loans, and many countries will need grants. The treatment of creditors remains an open question - one that will likely only be resolved once we get a fuller understanding of the fiscal threat to various EM countries.
As the financial shocks settle in, focus will turn to individual country fundamentals. In fact, this has already started, as concerns with Turkey and South Africa mount. New names to the "watch" list include Angola, Sri Lanka and Oman.
Bottom line: We expect the impact of the dual shocks of the virus and oil prices to be long-lasting. Governments have responded with unprecedented levels of fiscal and monetary stimulus, but their effectiveness remains to be seen. Thus, we are cautious on the asset class - professional due diligence and selectivity remain more important than ever.