Most financial markets sold off sharply in 2022’s first quarter in response to the war in Ukraine, rising inflation and expected interest-rate hikes. The S&P 500 delivered a -4.6% total return for the quarter, and the Bloomberg Aggregate U.S. Bond Index a -6.0% total return, due mostly to rising Treasury yields. Emerging markets debt did even worse in the broad-based flight from risk. The J.P. Morgan EMBI Global Diversified Index for hard currency sovereign bonds had a total return of -10.02%, which is only the fourth occurrence of a double-digit negative quarterly return since the index inception in 1994.

Widening credit spreads accounted for -4.0% of the EMBI’s negative return; rising Treasury yields, for the other -6.2% with a small positive contribution from interest returns. It's rare for credit spreads and Treasury yields to detract from returns simultaneously; typically, they move in opposite directions, cushioning investor returns (Figure 1). In the past decade, there were only two other periods of concurrent spread widening and Treasury yield rising: during the “Taper Tantrum” of 2013 and in 2018. In both cases, a surprising change in financing conditions loomed large.

In 2013, the Federal Reserve’s surprising decision to taper asset purchases provoked the market “tantrum.” In 2018, the Fed’s surprising decision to hike the Fed Funds rate from 1.50% to 2.50% caused a sell-off; the market had not responded strongly to rate hikes from 0% to 1.50%.

Similarly, in Q1 2022 the Fed said it would raise rates faster and sooner than the markets had expected. In this case, the Fed was responding to a one-two punch: a broad-based inflation surge (due to pent-up demand and supply-side disruptions) and a commodity price shock related to Russia’s invasion of Ukraine. The unexpected tightening of global financial conditions shocked the markets, negating the typically negative correlation between Treasury yields and credit spreads.

This Too Will Pass
But surprises tend to dissipate, and expectations do adjust. Sharp declines in emerging-market debt indices have typically been short-lived, and often the rebound has been rapid. After the sharp selloffs in 2013 and 2018, investors were rewarded for staying in the asset class or using market weakness as an entry point (Figure 2). There have also been periods in the last decade when both Treasury yields and credit spreads have declined, delivering exceptionally strong returns—most recently, in 2019 and early 2020. The pandemic rudely interrupted that “Goldilocks period” for Emerging Market Debt investors.

We believe that financial markets are likely to soon deliver the diversified sources of return that are key to asset allocation. While historical returns do not necessarily predict future returns, we maintain that credit spreads and Treasury yields are likely to return to moving in opposite directions, cushioning returns. Research and active management will be crucial to garnering the full potential benefit of a rebound, in our view. Once the initial shock wears off, markets should start to differentiate again among countries, companies and individual bonds, and returns will likely diverge sharply. We maintain that investors would benefit from research to identify the likely winners and losers.