South Africa Is Latest Headwind for Emerging Market Debt

August was a generally solid month for U.S. fixed income markets as longer-term interest rates declined, with most sectors posting positive returns.

However, August was difficult for emerging market debt (EMD). EMD, as measured by the Bloomberg Barclays EM USD Aggregate Index, returned -1.4% during the month. EMD underperformed domestic high-yield debt, represented by the Bloomberg Barclays US High Yield Index, by 2.0%.

Headwinds for EMD may continue in the short term, if recent headlines are any indication. South Africa’s currency (the rand) has weakened to a record low versus the U.S. dollar after data released on September 4 showed its economy fell into a recession last quarter. This development could be especially worrying for EMD investors, as it could potentially lead rating agencies to downgrade the credit rating of South Africa’s government debt.

Concern over South Africa’s situation is not simply about weakening economic growth. As shown in our LPL Chart of the Day, the country’s debt burden (especially the amount of debt denominated in foreign currency) is on par with Turkey’s debt, a country that also recently encountered mounting investor concern.

South African Debt Denominated in Foreign Currencies is on Par with Turkey

While other emerging markets are taking steps to manage their own fiscal situations, emerging market currency volatility continues to roil investors. Last week, Argentina’s peso posted its biggest drop versus the dollar since December 2015, after officials laid out an ambitious austerity plan that aims to slash government spending. Argentina’s central bank also hiked short-term interest rates to 60% (the highest in the world). Both of these actions are meant to recoup investor confidence by improving Argentina’s fiscal standing, but so far, these moves have not shored up confidence.

The Turkish lira also continued its sell-off last week, falling 8.1% versus the dollar. Turkey’s central bank vowed to adjust its monetary stance at its next meeting on September 13, following recent data that pointed to runaway inflation.

“Although there are risks that need to be monitored, the good news is that the EMD weakness has not spilled meaningfully into global credit markets,” LPL Research Chief Investment Strategist John Lynch explained. “High-yield bond markets in the U.S., Europe, and Asia aren’t showing material signs of stress from the fallout. Although contagion has not spread meaningfully, the ongoing risks to EMD need ongoing attention from investors.”

While recent turbulence has cheapened EMD relative to lower-quality alternatives such as high yield, we remain cautious on EMD for its exposure to currency weakness, protectionist trade policy, and idiosyncratic risks that we believe investors are still not amply compensated for.

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The Bloomberg Barclays Emerging Markets USD Aggregate Index is a flagship hard currency emerging market (EM) debt benchmark that includes fixed and floating-rate U.S. dollar–denominated debt issued from sovereign, quasi-sovereign, and corporate EM issuers. Country eligibility and classification as emerging markets is rules-based and reviewed annually using World Bank income group and International Monetary Fund (IMF) country classifications.

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