JP Morgan EMBI Global Diversified Index (lhs), DXY Index, inverted (rhs) Source: Bloomberg, UBS, February 2023.

After the equity market's trough in March 2020 following the outbreak of the COVID-19 pandemic, global bonds rose 10%. But when US inflation started surging rapidly above 4%, they fell 24%. And the gains and losses were even more pronounced for emerging market (EM) government bonds, which posted a 31% rise and a 28% decline, respectively.

This isn't surprising: US inflation prompted higher US rates and a stronger dollar, and that hurt EM bonds on both fronts.

As the chart above shows, since 2019 EMBI bonds have been inversely correlated with the DXY Index.

Now, this inverse correlation is a good thing for the EM bond outlook. This week, the Federal Reserve raised rates by 25 basis points after a series of jumbo hikes—a total of 425bps were added in 2022, including four 75bps increases. With moderating inflation, the Fed is moving away from aggressive tightening, while leading US growth indicators are pointing to softening economic activity. The ISM Manufacturing PMI fell to 47.4 in January from 48.4 in December.

While the US labor market remains too tight for the Fed to cut rates, a pause in rate hikes is likely by 2Q, in our view, and we expect interest rate differentials with the euro to narrow. The US dollar is likely to weaken further, with the DXY Index already down ~10% from its September 2022 peak.

Another important factor playing in favor of EM bonds is China's reopening. China’s policymakers have downgraded COVID management controls, and scrapped quarantine and PCR testing requirements for inbound travelers. In addition, authorities are prioritizing growth and promising a supportive stance. In our view, this should support consumption along with pent-up savings, and we continue to expect an economic recovery to around 5% GDP growth for 2023.

So, the backdrop has turned supportive for EM government bonds, and investors can benefit. EM bonds are starting the year with the highest yields since 2009: 8% for sovereign bonds (JPMorgan EMBIG Div.) and 6.8% for corporate bonds (JPMorgan CEMBI Div.). Historically, higher yields have typically been followed by higher returns over a 12-month horizon.

We now hold a most preferred stance on EM bonds. Unless a deep US recession materializes, which is not our baseline scenario, we expect mid-single-digit total returns over the coming six months (non-annualized), supported by carry and spread compression. This offers an interesting opportunity for investors to increase their allocation to select emerging market bonds.

We like sovereign bonds with attractive valuations, driven by the high yield segment. We also find value in SEC-registered Latin American bonds, a collection of corporate bonds in the short end of the yield curve, and bonds from oil and gas issuers. We also see idiosyncratic opportunities in countries such as Argentina.

Main contributor: Linda Mazziotta