JPMorgan Warns This Emerging-Market Credit Strength May Fizzle

Tai chi in the Bund area as the Oriental Pearl Radio & TV Tower, center, and other commercial buildings stand in the Lujiazui district in Shanghai, China.

Photographer: Tomohiro Ohsumi/Bloomberg

Try figuring this one out: Emerging-market stocks have gotten pummeled over the past few weeks while corporate bonds from the same regions have outperformed many other assets.

How does this make sense? It doesn’t really, especially as China shows more signs of slowing, said Scott McKee, head of an emerging-markets corporate-debt group at JPMorgan Chase & Co.’s asset-management unit.

“There’s a long list of fundamental issues that we could go through that suggest that emerging markets should be doing worse than other fixed-income sectors at the moment,” McKee said in a telephone call this week. “I don’t really understand why it’s been as resilient as it has been.”

A growing number of investors seem to agree with McKee, who recommends cutting holdings of the debt below index weightings.

Almost $2.5 billion was pulled from emerging-market debt funds over the past week, the biggest withdrawal since the beginning of 2014, according to EPFR Global data. Asia credit funds saw their largest outflow on record, according to Wells Fargo & Co. data.

Little Upside

Despite the exodus, developing-market company bonds are holding up pretty well -- especially compared with plunging stocks. The dollar-denominated debt has lost about 1 percent this month, compared with drops of 1.9 percent on U.S. high-yield bonds and almost 8 percent on emerging-market stocks, according to Bank of America Merrill Lynch and MSCI index data.

For the year, the emerging-market debt has gained 1.8 percent, more than the 0.3 percent return on U.S. company bonds of all ratings. Part of that outperformance is due to a rebound in the notes of Ukraine and Russia, with bonds of the Moscow-based VTB Bank, for example, gaining 21.3 percent this year.

Some strategists are getting increasingly pessimistic about whether this kind of performance can last.

“We don’t see much upside for EM credit,” Bank of America Corp. analysts Chris Hays, Camila Torrente and Anne Milne wrote in an Aug. 18 report.

JPMorgan’s McKee said he became particularly bearish on the notes starting in June, largely on concern about the fundamental outlook for developing nations, particularly in Asia. A Chinese manufacturing gauge fell to the lowest in more than six years this week, suggesting the economy will need further policy support.

Dangerous Terrain

Assets in developing nations are often among the hardest hit by signs of slowing global growth. About 20 percent of the emerging-markets universe relying on profits from commodities that have tanked along with economic expectations, McKee said.

They also stand to lose value when the Federal Reserve raises interest rates for the first time since 2006, possibly as soon as this year. That’s because higher rates in developed markets will ostensibly lead investors back to steadier economies rather than taking more of a risk for bigger returns in more-fragile ones.

Investors will have to tread carefully through this terrain in the upcoming months, with the risk of economic land mines growing.

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