Morgan Stanley bets on emerging market debt as JPM says rally unsustainable

While JPMorgan Chase & Co. is urging investors to use an “unsustainable” rally in emerging-market bonds to ditch debt from some of the riskiest corners of the world, Morgan Stanley is recommending they pile up on it. 

A lower-than-expected US inflation reading released Wednesday should support developing-nation bonds, Morgan Stanley strategists led by Simon Waever wrote in a note, turning bullish on sovereign credit for the first time since November 2020. Just a day before, JPMorgan strategists led by Trang Nguyen said the recent rebound in the asset class won’t last long, suggesting clients dump less liquid names at opportunistic prices and buy cheaper hedges to protect against selloffs. 

Goldman Sachs Group Inc. is similarly cautious, as it sees tightening US financial conditions posing upside risks to EM yields, strategists led by Davide Crosilla wrote in a note.

The latest inflation data from the US spurred a risk rally as traders reduced Federal Reserve tightening wagers. The extra yield investors demand to hold emerging-market sovereign debt over US Treasuries narrowed Wednesday, extending the trend since mid-July, when spreads on the JPMorgan index peaked at the highest levels in over two years. 

The strong performance in the last weeks has helped the gauge trim some losses. It’s still down almost 17 per cent in 2022 and on course for its worst year since 1994 as investors fret the era of easy money ending will result in a cascade of defaults from struggling emerging nations.

“While imminent recession fears have eased compared to our last report one month ago, the combination of tighter monetary conditions and lingering recession risks should continue to pose key cyclical headwinds for EM sovereigns,” according to JP Morgan analysts. “Given the technical nature of the rally, we exercise caution and tilt our portfolio more defensively.”

In the short term, spreads may continue to shrink as inflows to the asset class returned last week for the first time since early April and they tend to stay for months. Valuations are not yet stretched and primary markets remain dormant, keeping cash levels abundant, they wrote. 

Nguyen’s team cut a recommendation in Honduras and Azerbaijan’s dollar bonds to marketweight from overweight as they see limited scope for a further rally. They now have overweight positions in Romania, adding to already existing ones in Serbia, Indonesia and Sri Lanka. They have underweights in debt from Armenia, Barbados, Costa Rica, Kenya and Turkey. The firm also upgraded the Philippines to marketweight. 

Meanwhile, Goldman said that as long as rate hikes continue to push up front-end yields and curves remain mostly inverted, the bar for strong and sustainable gains will remain high. The company favors receiving rates in Latin America over other emerging markets as inflation is expected to slow in most of the region while remaining elevated in central and eastern Europe as well as Asia.

On the flip side, Morgan Stanley is dialing up risk, recommending money managers add high-yielding bonds from Egypt, Ukraine and Colombia. That’s in addition to risky bets Waever’s team already had on Argentina, El Salvador, Zambia and Mozambique. Among the higher-quality credits, they recommend Romania, Mexico and Panama. 

Still, it’s too soon to call an all-clear on the external factors, according to Waever, but the spread on the index may shrink as much as 50 basis points in the next few months, led by B-rated nations.  

“The total returns of the index have already shown signs of rebounding, bringing with them new inflows,” Waever’s team wrote. “With little scope for a significant pickup in primary issuance in August, secondary market spreads will have to be the key destination of these flows.”