10 Dec 2021
The challenging global backdrop for bond markets this year is reflected clearly in EM debt market performance. Behind headline figures – negative year-to-date returns outside of the corporate debt sphere – there has been plenty of dispersion: Turkey is a notable outlier on the negative side (FX sell-off resulting from unorthodox monetary policy) and Ecuador has stood out on the positive side (hard currency bonds gained after a market-friendly presidential election result and expectations of ongoing engagement with the IMF).
Overall, markets grappled with three key challenges:
While volatility is likely to continue as we enter 2022, there are reasons to remain positive over the outlook for next year. EMs are stronger both structurally and fundamentally than they were before the taper tantrum of 2013, leaving them much better placed to withstand turbulence in the event of US interest rate hikes. Furthermore, the cyclical growth story remains intact, albeit at a slightly slower pace than hoped. Considering valuations, EM debt remains compelling relative to DMs – especially on the FX and local rates side, which are nearing their most attractive levels for 10 years.
Please see Investment Views 2022 to learn more about our outlook for next year.
As was highlighted during COP26, EMs will play a vital role in determining the world’s success in transitioning to net zero. As of today, EMs’ contributions to global emissions are relatively high, given their less developed status and higher economic growth rates. These countries need targeted capital to help make the necessary shifts towards a more sustainable future, and their economies need to be allowed to catch up with DM peers.
Given this, investors should be wary of crude approaches that simply exclude EMs when seeking to lower their portfolios’ carbon footprint. What might appear to tick a box for a portfolio’s green credentials may do nothing to help the world reach net zero. In fact, by starving EMs of the capital they need to invest in renewable energy and associated infrastructure, the effect could be to frustrate transition efforts.
One of the themes to arise from COP26 is the need to judge EMs differently to the way we consider DMs. We need to give EMs more leeway, at least initially; we need to engage with policymakers in these markets; and we need smarter measures to hold them to account in achieving a transition to net zero.
We take the view that a portfolio should allocate capital in a way that helps EMs on the path to net zero and we believe the investment community should move away from a myopic focus on carbon intensity and towards a focus on a fair transition. The concept of fairness is key to us, given that most EMs are not responsible for the bulk of global emissions to date.
We think in terms of a fair transition path to net zero - for EMs, the pace at which emissions are reduced might need to be slower (i.e., a less steep path) than for western economies to allow them more room to grow, retain jobs, and tackle poverty. A country’s fair pathway depends on its stage of development – poorer nations, such as India, desperately need economic growth to alleviate poverty so should be given more leeway/time to reach net zero. It is this thinking that lies behind our Net Zero Sovereign Index.
To create the index, we built on the highly regarded Germanwatch Climate Change Performance Index approach, which covers 25 countries, and expanded this to cover 117 countries – including developed and emerging markets.
A key difference between the Net Sovereign Index and other ESG measures is its relatively low correlation with a country’s income level. In our view, a poor country that is making the right policies and moving in the right direction deserves recognition for that, even if its initial level of carbon intensity is high; whereas a rich country that has a lower level of carbon intensity but is not investing enough in renewables should be penalised for not doing enough in terms of its transition pathway.
You can find out more about our methodology here. In summary, here are the six components of the Net Sovereign Index:
A general observation from the Index is that lower income countries are typically doing what we think they should be doing, while many DM countries aren’t quite sticking to their (stricter/more stringent) pathways, but score better for policies. Focusing on renewable energy, this makes up a surprisingly large share of installed capacity in African and Latin American countries, boosting some of the scores there. At an individual country level, highlights (and lowlights) include:
For us, the index is proving to be an important and useful tool for assessing countries’ environmental performance – a measure that we supplement with our in-depth qualitative assessment. The index builds on the Climate and Nature Sovereign Index (CNSI), which assesses individual markets’ climate risk exposure. The Net Zero Sovereign Index supplements the CNSI by providing the perspective of the energy transition. Both are useful tools for engaging with policymakers – acting as a yard stick and providing context for conversations.
For investors, we think the index provides a useful lens through which to view a portfolio – measuring its alignment with net zero in a meaningful way. It can also be used to guide investments for investors looking to set specific net-zero portfolio targets.
We are active participants in the PRI’s sovereign working group and involved in the Assessing Sovereign Climate-related Opportunities and Risks (ASCOR) project which is tasked with developing tools to assess sovereign climate-related opportunities and risks. We hope that this will result in the Net Zero Sovereign Index – which aims for greater alignment with the Paris objectives – becoming more broadly available, providing investors a strong platform to progress down a better path.
Emerging market: These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.
All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.