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Sell-off improves EM debt valuations, but large risks still loom

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      By Global Income Team, Eaton Vance Management

      Boston - The third quarter for emerging-market (EM) debt was a tale of two halves. The EM indexes continued to sell-off for much of the first half, but recovered sharply toward the end. Local-currency debt performance finished in negative territory, while sovereign and corporate spreads recovered. Differentiation between countries continues to be significant, though problems have begun to spread.

      In the first half of the quarter, the sell-off appeared to be driven by the problems of Turkey and Argentina, which have both seen their currencies fall sharply against the dollar in 2018. As the situation in those countries found relative stability midquarter, the rest of EM rallied significantly.

      The poor performance of rates and foreign currency risk factors set apart local-currency sovereign debt from the rebound experienced by dollar-denominated corporate and sovereign debt (see chart).

      2018_10_16_TotalReturn.png

      Looking forward, value is starting to open up in the asset class in the wake of the sell-off. However, with a challenging macro and technical environment, we expect volatility in the asset class to persist. Asset flows have remained remarkably resilient, despite the volatility. While asset flows may have been a moderating force for the sell-off so far, it also poses a major risk if sentiment worsens and flows reverse in the fourth quarter.

      The U.S. Federal Reserve remains on course with a rate-hiking cycle, but the market is just beginning to price in the dislocations this could cause across capital markets. Moreover, the Trump administration, along with an increasingly assertive Congress, is a major risk to the asset class. The list of countries facing the threat of U.S. sanctions is becoming too long to count.

      The importance of country-specific fundamentals will depend on overall asset class performance, in our view. If EM debt muddles through, individual country fundamentals will be key. In aggregate, country fundamentals are not improving, and this is becoming more of a concern in a number of key countries. However, these risks are now balanced with more realistic valuations.

      Bottom line: The 2018 sell-off in EM debt has made valuations more attractive, but there are still numerous technical and fundamental question marks looming. Investors considering the EM debt market should rely on country-specific due diligence and careful evaluation of risk factors.