COVID-19 has changed the landscape for emerging markets (EM) debt, injecting a broad new dimension of pandemic-related economic uncertainty. The impact varies widely across EM countries - in many ways, the imperative to balance "lives vs. livelihoods" parallels the challenges faced by developed economies. But many EM countries with less diversified, less resilient economies also have unique problems that are exacerbated by the pandemic, especially among the poorest and most vulnerable populations.
From an investment management perspective, today's environment underscores the key tenets the Eaton Vance EM debt team has developed over the past several decades. Most EM strategies are based on common indexes like the JP Morgan Emerging Market Bond Index (EMBI) for dollar-denominated, sovereign bonds, or the JP Morgan Government Bond Index - Emerging Markets (GBI-EM) for local-currency denominated debt.
There are several key reasons why benchmark-based approaches may be suboptimal.
For one, benchmark valuations may be unattractive, from an asset price perspective, at any given time. Nevertheless, they are - by definition - required holdings for benchmark-based strategies.
Further, indexes may be highly concentrated - for the GBI-EM, the top 10 countries account for 80% of its weight, as of September 30, 2020. This kind of concentration of a relative handful of larger EM issuers has been a major source of the index's historical volatility. The market impact of this concentration has grown along with the rise of index-based EM ETFs.
In contrast, outside of the GBI-EM there are 70 investable markets, with approximately $1.1 trillion worth of local-currency market capitalization. Non-benchmark securities are not as well covered by sell side analysts so they more frequently mispriced. Strategies that rule out such countries greatly reduce the opportunity set and alpha potential. In brief, investing in EM countries simply because they are in a benchmark has always been a weak premise, and it is even more so after COVID-19.
The Mexican dilemma
Consider Mexico, which represents about 10% of the GBI-EM. It is one of the poorest countries in the western hemisphere, and its healthcare system is in shambles, with one of the lowest testing rates for COVID-19. Because much of the employment base is part of the informal economy, many workers can't shelter in place or even have paychecks deposited automatically.
Yet as part of the global supply chain, the country faces tremendous pressure to reopen its economy, evidenced by the government's decision to designate automakers an "essential" industry. New cases of COVID-19 continued to remain elevated in Mexico, well after six months of the pandemic. Whether it can sustain economic reopening with the major problems in healthcare and testing is a major question.
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An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. As interest rates rise, the value of certain income investments is likely to decline. These risks may be more significant in emerging markets due to increased risk of adverse market, economic, political, regulatory, geopolitical and other conditions. These risks are magnified for investments that focus on a single country or region. Important Additional Information and Disclosures Source of all data: Eaton Vance, as of October 31, 2020, unless otherwise specified.
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