February 2021 Five reasons to be bullish on local-currency emerging-market debt We are broadly bullish on emerging-market debt Michael Cirami Director of Global Income (EMD) – particularly local-currency EMD – as we Eaton Vance Management expect the notably positive turn in the macro Matthew Murphy Jr., CFA, CAIA Senior Institutional Portfolio Manager environment to continue. Global Income Team Eaton Vance Management EM economic growth is leading the global economic recovery, yet EM returns in 2020 lagged the asset gains in developed markets. EM economies did not shut down to the same degree as developed economies in 2020, nor are they shutting down as aggressively now. Developed-market monetary policies will continue to anchor core interest rates at extremely low levels, including around U.S.$18 trillion of negative-yielding debt. Combined with ballooning deficits in the U.S., the dollar is likely to remain weak. Crossover buyers into EMD, along with widespread interest in the higher yields available in the asset class, will likely continue to provide support. Some countries are experiencing a debt buildup. Successful investment in this diverse asset class requires, in our view, proper due diligence and attention to country-specific risk. 2 | Five reasons to be bullish on local-currency emerging-market debt | February 2021 Introduction a handful of EM countries between April and October 2020. Relative to the outlook for developed economies, Eaton Vance is currently upbeat about the investment the International Monetary Fund (IMF) projects a prospects for local-currency-denominated emerging- stronger rebound in emerging economies in 2021.² See market debt (EMD). The Eaton Vance EMD team Exhibit A. managing U.S.$8.4 billion in assets has EM FX as a clear “overweight” risk factor for the first time ever. The team is simultaneously positive (“moderate overweight”) on 2. Emerging-market debt assets have lagged the EM local interest rates, EM sovereign credit and EM rally in developed-market assets corporate credit.¹ Despite the positive growth differentials, emerging- Reasons for this bullish stance include dovish policies of market debt (EMD) assets lagged the recovery in a G3 central banks, low yields in core bond markets, number of developed-market assets in 2020. This lag increasing deficits in the United States and attractive was most evident in the EM currency markets, where relative valuations. Below, we look in more detail at the many of the worst hit currencies in March and April reasons for this upbeat outlook, particularly in relation 2020 were still in negative territory at the end of 2020. to local-currency debt. In aggregate, EM currencies finished the year down 7.35% overall. Exhibit B shows the total returns posted 1. Emerging economies are driving the rebound in by the three widely used J.P. Morgan EM debt indices as well as Eaton Vance calculations of return components. global economic growth In Exhibit B, we also see that EM sovereign spreads and Emerging-market economies did not shut down to the corporate spreads were in negative territory for 2020. degree that occurred in developed-market economies Compared to EMD local currency – as represented by in the face of COVID-19 in 2020, and neither are they the J.P. Morgan Government Bond Index Emerging are shutting down as aggressively now. While Markets (GBI EM) Global Diversified – developed- significant growth downgrades for 2020 due to market sovereign bonds, global corporate credit, both COVID-19 have continued – with several countries, investment grade and noninvestment grade, and including Zambia and Suriname, being added to the list emerging-market credit, both sovereign and corporate, of defaulting countries in the fourth quarter of 2020 – all fared better in 2020.³ there was some improvement in the growth outlook for Exhibit A IMF forecasts stronger rebound for emerging-market and developing economies Real GDP growth (annual percentage change) Trend 1980-2025 10 2021 5 0 2021 forecast (annual percentage change) -5 Emerging market and developing economies 6.0 Advanced economies 3.9 World 5.2 -10 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Advanced economies Advanced economies (predicted) Emerging-market and developing economies Emerging-market and developing economies (predicted) World World (predicted) Source: IMF, December 2020. ¹Source: Eaton Vance. AUM data for the EMD team is as at December 31, 2020. Views correct as at January 24, 2021. ²One reason the economic dynamics in a number of developing countries has improved is the recent rally in oil prices and commodities more broadly. ³Source: Morningstar as of December 31, 2020. Past performance is not a reliable indicator of future results. Performance of EMD local currency is relative to various main asset groupings, including Global Agg Ex-U.S. (represented by Bloomberg Barclays Global Aggregate Ex USD Index), Investment Grade debt (represented by Bloomberg Barclays U.S. Corporate Index), U.S. Treasurys (represented by Bloomberg Barclays U.S. Treasury Index), U.S. High Yield bonds (represented by ICE BofA U.S. High Yield Index), Municipal bonds (represented by Bloomberg Barclays Municipal Bond Index) and Bank Loans (represented by S&P/LSTA Leveraged Loan Index). 3 | Five reasons to be bullish on local-currency emerging-market debt | February 2021 3. The macro environment is very favorable for assets), the U.S. dollar thus weakens. For EM EM debt economies, a weaker U.S. dollar helps them to grow, which typically reduces their external vulnerabilities, Further, we believe we are seeing one of the most and benefits the local currency. favorable macro environment for EM debt in decades. Most EM central banks appear to be at the end of their Monetary policies by developed-market central banks easing cycles. Meanwhile, EM local rates have the have never been more accommodative. In the United potential for real interest-rate differentials with G3 States, the Federal Reserve has adopted Average (despite being inside long-term averages), to move Inflation Targeting (AIT) and taking Fed Chair Jerome lower amid easy monetary policy and a disinflationary Powell at his word, we do not foresee a tightening of trend. Low developed-market yields are also an anchor. U.S. monetary policy any time soon. This means real rates in the U.S. are likely to remain in negative 4. Positives for EM debt assets are not priced in territory for the foreseeable future, which (all else equal) reduces demand for the U.S. dollar. Other The positives for EMD – better growth in emerging- developed-market central banks – notably, the market economies, relatively attractively priced EM European Central Bank, Swiss National Bank, Bank of debt assets and a very favorable macro environment in England and the Bank of Japan – have meanwhile decades – are, on the whole, not priced in. embarked on the largest round of asset purchases True, the fourth quarter of 2020 saw strong flows of (“QE”) in modern history. The result? There is now approximately U.S.$78 billion into EM assets (of which roughly U.S.$18 trillion worth of negative-yielding debt U.S.$30 billion was into EM bonds).⁵ Market sentiment in the world and 76% of the developed world’s fixed- was buoyed by news of COVID-19 vaccine 4 rate sovereign debt has a negative real yield. Against developments, a U.S. presidential election win for Joe this backdrop, the impetus for investors to send Biden, continued accommodation by the world’s central capital to EMD in search of yield is substantial. banks, core bond yields remaining near historic lows, Aside from adopting AIT, the U.S. is expected to the U.S. dollar weakening notably, and emerging-market increase its twin deficits (budget deficit and current countries, in aggregate, achieving better growth than account deficit) even further under the Biden expected and posting slightly smaller deficits than had administration, which is likely to send the U.S. dollar been expected. lower versus just about everything (see Exhibit C). However, this strong finish to 2020 did not occur The reason is as follows. First, fiscal stimulus is often without being preceded by the largest EM local inflationary, which reduces the real return available portfolio outflows (equities and local-currency bonds) on U.S. assets and dampens demand for the U.S. ever recorded; outflows surpassing those of the dollar. Second, fiscal stimulus typically drives a wider financial crisis in 2008, the taper tantrum in 2013 and trade balance (imports exceeding exports), which the China scare in 2015.⁶ Relative to these earlier increases demand for foreign currency. All things outflows in 2020, not much has actually returned. In equal (i.e., unless the USD sold for traded goods and 2021, we expect capital will continue to flow back into services floods back into the U.S. to buy financial EMD because yield-seeking investors need positive cash flow now, which, in our view, is abundant in EMD. Exhibit B EMD asset class return analysis – 2020 EURUSD Sovereign Corporate Exchange Credit Credit U.S. Total Emerging-market debt index FX Rate Move Rates Carry Spread Spread Treasury Return (Local-currency sovereign) J.P. Morgan GBI-EM Global -7.35% 1.77% 2.83% 5.45% - - - 2.69% Diversified (Hard-currency sovereign) J.P. - - - - -2.84% -0.35% 8.44% 5.26% Morgan EMBI Global Diversified (Corporate debt – U.S. dollar) J.P. - - - - 1.89% -0.78% 6.03% 7.13% Morgan CEMBI Broad Diversified Sources: J.P. Morgan, Eaton Vance calculations. Data is as at December 31, 2020. The J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified is an emerging-market debt benchmark that tracks local-currency bonds issued by emerging-market governments. The J.P. Morgan Emerging Markets Bond Index (EMBI) Global Diversified is an unmanaged index of USD-denominated bonds with maturities of more than one year issued by emerging-market governments.