Morgan Stanley bets on EM debt as JPM warns rally not sustainable

(Bloomberg) – As JPMorgan Chase & Co. urges investors to use an “unsustainable” rally in emerging market bonds to ditch debt from some of the world’s riskiest corners, Morgan Stanley recommends they pile in there .

A weaker-than-expected reading of U.S. inflation released on Wednesday should support developing-country 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, strategists at JPMorgan led by Trang Nguyen said the recent rebound in the asset class won’t last long, suggesting clients sell less liquid stocks at opportunistic prices and buy hedges. cheaper to protect against overselling.

Goldman Sachs Group Inc. is similarly cautious, as it sees tightening financial conditions in the United States posing upside risks to emerging market returns, the strategists led by Davide Crosilla wrote in a note.

The latest US inflation data spurred a rally in risk as traders reduced Federal Reserve tightening bets. The extra yield demanded by investors to hold emerging market sovereign debt relative to US Treasuries tightened on Wednesday, continuing the trend since mid-July, when spreads on the JPMorgan index peaked at their highest levels. high levels in more than two years.

Strong performance in recent weeks has helped the gauge pare some losses. It is still down almost 17% in 2022 and on track for its worst year since 1994 as investors worry the end of the easy money era will lead to a cascade of defaults. from struggling emerging countries.

“While fears of an impending recession have subsided compared to our last report a month ago, the combination of tighter monetary conditions and lingering recession risks should continue to pose key cyclical headwinds for sovereigns. emerging markets,” according to analysts at JP Morgan. “Given the technical nature of the rally, we are exercising caution and orienting our portfolio more defensively.”

In the near term, spreads could continue to contract as inflows into the asset class returned last week for the first time since early April and tend to hold for months. Valuations are not stretched yet and primary markets remain dormant, maintaining plentiful cash levels, they wrote.

Read: Bluebay sees attractive valuations on EM hard currency debt

Nguyen’s team has cut its recommendation on dollar bonds from Honduras and Azerbaijan to overweight the market as it sees limited room for a further rally. They now have overweight positions in Romania, in addition to those already in place in Serbia, Indonesia and Sri Lanka. They are underweight in the debt of Armenia, Barbados, Costa Rica, Kenya and Turkey. The company also upgraded the Philippines to market weight.

Meanwhile, Goldman said that as long as rate hikes continue to drive up initial yields and the curves remain mostly inverted, the bar for strong and sustainable gains will remain high. The company favors reception rates in Latin America over other emerging markets as inflation is expected to ease across most of the region while remaining elevated in Central and Eastern Europe and Asia.

On the other hand, Morgan Stanley is increasing the risk, recommending fund managers to add high yield bonds from Egypt, Ukraine and Colombia. This is on top of the risky bets Waever’s side already had on Argentina, El Salvador, Zambia and Mozambique. Among the higher quality credits, they recommend Romania, Mexico and Panama.

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Still, it’s too early to be clear on external factors, according to Waever, but the spread on the index could narrow by up to 50 basis points over the next few months, led by B-rated countries.

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

(Updates with Goldman’s comments in 3rd and 9th paragraphs.)

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