2022 Investment Views: Emerging market sovereign debt

Cutting through the noise

A more benign backdrop should allow the attributes of emerging market debt to shine through.

Nov 24, 2021

3 minutes

Werner Gey van Pittius
A more benign backdrop should allow the attributes of emerging market debt to shine through.

The fast view

  • With the recent faster pace of vaccinations helping emerging market (EM) economies to reopen and restoring supply-chain integrity, we expect a more benign inflation and growth backdrop and lower market volatility in 2022.
  • Central banks in EM have acted much faster than their developed market (DM) peers in hiking rates to tackle inflation. We think yields in some of these markets are starting to look really attractive.
  • With less freedom to borrow and spend their way through the pandemic, EM economies are now in a much better fiscal position than DM economies, on average. We believe market valuations will start to reflect this disparity.
  • EM debt valuations are currently at enticing levels from a historical perspective; we are poised to add more top-down risk when conditions normalise in the dollar and US Treasury market.
  • Relative-value opportunities abound, including Russian ruble vs. Colombian peso (both oil exporters but with very contrasting fiscal positions) and Asian markets that are reopening vs. vaccination laggards.
QWill next year be a smoother journey for investors?

EM debt markets have been incredibly volatile in recent months, fuelled by a combination of fears around inflation and concerns over COVID-related lockdowns/supply-chain disruption. In 2022, we expect each of these drivers to wane, which could create a smoother market backdrop.

The vaccination rates in EM have really picked up pace, especially in Asia, allowing economies to reopen and restoring supply-chain integrity. All else being equal, we think inflation should moderate and growth should return in most markets in 2022. Coupled with the compelling current valuations in EM debt, we think this points to a bright outlook for the asset class from a risk-adjusted return perspective.

QWhat’s your view on inflation risks?

Globally, market participants are getting better at pricing in risks associated with rising inflation. As for EM, we see an interesting opportunity arising from much more aggressive monetary policy than that seen in developed markets. In EM, central banks have acted faster in hiking rates. In some cases, we think markets are now pricing in more EM rate hikes than are likely to be needed – in effect, overestimating inflation risks. Moreover, the gap between EM and DM forward policy rate expectations is at historical highs, both in nominal and real (inflation-adjusted) terms. The result is that EM bond yields (and, therefore, prices) are starting to look really attractive.

QHow robust is the macro outlook?

Aside from the proactive/orthodox monetary policy mentioned above, we think the relative fiscal prudence of many emerging markets will also move onto investors’ radars in 2022.

Developed markets have enjoyed much greater freedom than emerging markets when it comes to increasing borrowing and spending in response to the pandemic. In effect, EMs are on a much shorter leash and forced to be relatively prudent – something that markets have not given them full credit for. Fiscally, many EMs are now in better shape than western economies and we think this DM vs. EM disparity will become more apparent to the investment community in 2022.

QWhat is your investment strategy?

We currently describe ourselves as having ‘aggressively neutral’ top-down positioning in our EM sovereign debt strategies: we certainly have risk on the table and find current valuations very compelling, but we are waiting for the right conditions to take a more risk-on stance.

We find currencies, real effective exchange rates and bond yields to be at very attractive levels. Yet with US Treasury yields pushing higher, it is a bit too soon to put more risk on the table. We are looking for a more stable dollar and Treasury market before we move to more aggressive top-down positioning.

QWhere do you see the best opportunities?

The pandemic has increased dispersion among an already diverse opportunity set, creating plenty of opportunities for active managers. Among the relative-value trades we like at the moment is the Russian ruble vs. the Colombian peso. Political risk in the former accounts for some of its risk premium but Russia has a strong balance of payments position, and the high oil and gas prices are working very well for it. In contrast, Colombia, also an oil exporter, is seeing a fall in oil production and a current account deficit – a situation completely at odds with what we would expect for an oil exporter at the moment.

Looking through a different lens, we favour markets that are poised to benefit from re-opening over those that are lagging on COVID vaccinations. We see Singapore and Indonesia as falling into the former category, while Thailand and Philippines are struggling on tourism and vaccinations respectively and this is likely to hold back a recovery in their asset prices.

Authored by

Werner Gey van Pittius
Portfolio Manager

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