Emerging Markets (EM) debt partially retraced 1Q21 losses in April, driven by a combination of continued signs of a global economic recovery and stabilization in U.S. Treasuries. EM bond funds had net inflows of $4.6bn in April 2021, a reflection of the lower volatility backdrop.

Our outlook is in line with our views in the first quarter letter. EM is an asset class that tends to benefit from stronger growth, particularly in the early stages of a business cycle. We forecast global growth to recover to 5.7% in 2021, up from -3.4% in 2020. In addition, EM growth is closely tied to China, which is forecast to grow 8-8.5% despite some policy tightening. We are monitoring the situation in India, as well as specific idiosyncratic events in individual countries, but overall, we continue to see signs of economic improvement.

As for valuations, EM still looks attractive relative to its own history and to other fixed income asset classes in our view. EM sovereign spreads are currently 340 basis points (bps), only 10 bps tighter than the beginning of the year and still 40 bps wide to the long-term average of 300 bps. In addition, EM credit is trading at the wider end of its range over the last two years versus Developed Markets (DM) credit, which has tightened more aggressively. While the COVID response has led to some deterioration in EM credit quality, we believe the downgrade cycle in EM is bottoming and believe sovereign spreads could tighten further from here. In our view, the Fed will keep policy rates stable over the next 12 to 24 months. A more stable rates backdrop, in addition to spread tightening and carry of around 5.0%, looks attractive to us. Furthermore, diversification arguments support owning EM debt in a global portfolio, particularly in a low yielding world.

EM local currency debt rallied in April as the dollar fell 2%. As COVID cases decline and vaccine dissemination improves in Europe, we are monitoring for opportunities to add local currency exposure in the second half. Over the long term, we believe that the record U.S. fiscal deficit and growing current account deficit will pressure the dollar; there is a close inverse relationship between twin deficits in the U.S. and the strength of the dollar with a lag of approximately two years. In addition, a higher funding requirement necessitates the U.S. to offer higher cash rates to keep the currency stable. If the Fed does not hike until 2024 – or even 2023 – cash rates are likely to prove inadequate to sustain the dollar’s recent momentum in our view. As a consequence, we believe opportunities will arise to add local currency debt to the total return portfolio.