Emerging-markets debt gained 6.15% in the third quarter, according to the J.P. Morgan Emerging Markets Bond Index Global Diversified Index. The asset class was buoyed by the Federal Reserve's long- anticipated pivot to cutting interest rates, as well as some country-specific factors, which provided a favorable backdrop.
The shift toward global monetary easing gained steam when the Fed lowered its benchmark federal funds rate after a historic hiking cycle that began in March 2022 to combat persistently high inflation. On September 18, the central bank cut rates by 0.50 percentage points, opting for a bolder start in making its first rate reduction since March 2020. The Fed's stated goal is to achieve a soft landing for the U.S. economy: bring down inflation amid a gradual cooling in the labor market while neither spurring nor slowing economic activity. The Fed has projected the equivalent of two more quarter-point cuts this year. This should allow more room for central banks in emerging markets - some of which lowered rates last year - to ease further.
The J.P. Morgan index gained 1.87% in July, as hopes for a Fed rate cut and lower U.S. Treasury yields boosted emerging-markets debt. Narrowing yield spreads and idiosyncratic factors boosted the index in August (+2.32%). In September, the index rose in anticipation of the Fed's meeting and continued to climb after the rate cut. In addition, China announced a flurry of new policies toward the end of Q3, supporting property and capital markets. The 1.85% gain for the month bumped the index's year-to-date gain to 8.64%.
Against this backdrop, most of the index's country constituents gained in Q3, with the high-yield component of the benchmark modestly outpacing the investment-grade portion.
As a result, the return spread between countries was rather narrow, with some of the top performers boosted by idiosyncratic factors. For instance, El Salvador gained 19% in the third quarter. The bonds rallied in August after the International Monetary Fund issued a statement acknowledging progress made in achieving a new lending deal with the country. The IMF said the fund-supported program will be "focused on policies to strengthen public finances, boost bank reserve buffers, improve governance and transparency, and mitigate the risks from bitcoin."
Ecuador (+17%) and Argentina (+16%) also outpaced the broader index in Q3. In July, Ecuador's Finance Minister Juan Carlos Vega laid out funding plans and reported that the country's fiscal deficit had narrowed. The IMF approved a $4 billion fund for Ecuador in May. The country also benefited in August from the approval of a $500 million loan from the Inter-American Development Bank.
Meanwhile, Argentina's bond market outperformed because President Javier Milei's government continued to push tough austerity packages to tame inflation and the fiscal deficit. However, tension rose and protests erupted late in the quarter when lower house lawmakers voted to block proposed pension hikes that had been opposed by Milei.
Conversely, Venezuela (-10%), which was reintroduced into the J.P. Morgan index on April 30, underperformed the broader market. In late July, the results of the country's election were contested, as both President Nicolas Maduro and opposition rival Edmundo Gonzalez claimed victory. Venezuela's electoral authority announced Maduro won a third term in office. The U.S. Secretary of State expressed "serious concerns" with the election results.
Sri Lanka also lagged the benchmark, returning -4% the past three months. The country, which defaulted in 2022, continued to struggle to negotiate with its creditors.
For the quarter, the fund's Retail Class shares gained 5.00%, lagging the 6.15% advance of the benchmark, the J.P. Morgan Emerging Markets Bond Index Global Diversified Index.
In the third quarter, we continued to focus on sovereign and quasi-sovereign debt denominated in U.S. dollars, and, to a lesser extent, on local-currency debt and emerging-markets corporate securities. In managing the fund, we seek to consistently outperform the fund's benchmark, which is denominated in U.S. dollars.
Security selection detracted from the fund's performance versus the benchmark for the three months. Country positioning hurt to a lesser degree. By country, our bond choices in Ukraine detracted most, as it missed a Eurobond coupon payment in August before bondholders signed off on a $20 billion debt restructuring deal in September. As a result, major ratings agencies Fitch and Standard & Poor's downgraded the country's debt.
An overweight in Venezuela also detracted from the fund's relative result in Q3, given this bond market's underperformance. Venezuelan bonds returned to the J.P. Morgan index in late April, after having been removed from in 2019. The fund's holdings in Venezuela securities returned roughly -12% for the quarter.
Elsewhere, security selection in Brazil and Ghana hurt versus the benchmark. Exposure to energy issuers in these markets was a negative, as oil prices dipped on worries about the outlook for global demand.
Conversely, it helped to underweight China, which gained about 4% in the index, trailing the broader market along with other issuers of higher-quality bonds. Historically, the fund has largely avoided this market due to unattractive valuations and lack of financial transparency among state-owned issuers of enterprise debt.
Security selection in Mexico, Oman and Qatar also contributed the past three months.
As of September 30, asset markets enjoy favorable momentum and easier financial conditions. The shift toward global monetary easing gained steam this quarter, as the U.S. Federal Reserve cut its policy rate and bond yields dropped. The Fed has projected the equivalent of two more quarter-point cuts this year, which we believe should be a positive for the asset class.
Moreover, central banks in emerging markets have adjusted monetary policy to near-term inflation trends more quickly than many other regions around the globe. Further global rate cuts could support emerging markets, in our view.
While global monetary tightening appears to be over, the pace and magnitude of easing remains uncertain. Near-term recession risks appear muted, but a full pivot to a disinflationary mid-cycle environment remains uncertain.
In addition, geopolitical risk remains elevated. We are closely watching the Russia-Ukraine and Israel-Hamas wars, U.S.-China relations, U.S. elections, and economic uncertainty in a number of emerging markets.
Changes to the portfolio were minimal the past three months, but we'll note that we added exposure to Malaysia, Turkey and Saudi Arabia, whereas we reduced the fund's allocation to Venezuela.
As of September 30, the fund is overweight corporate bonds and underweight sovereign bonds, due to better valuations and fundamentals in the former category.
As the last quarter of 2024 begins, the top country overweights are in Venezuela, Mexico, Brazil, Nigeria and the Dominican Republic, whereas underweights are most pronounced in China, Poland, the Philippines, Bahrain and Uruguay.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.