Nov 24, 2021
The significant volatility seen in 2021 has been driven by a combination of factors. Uncertainty over the global macro outlook, divergence in terms of the timing/extent to which economies have reopened, and a less clear and more diverse growth outlook have all played a role. However, the dominant driver has been the market reaction to policy developments in China.
While there has been a significant focus on China throughout the year – specifically, the impact of regulatory tightening and liquidity in the real estate sector – this has intensified in recent weeks, with spreads on Chinese real estate corporate bonds increasing to their widest levels in a decade in November. Despite this, the EM corporate debt market in aggregate has been remarkably resilient; the JP Morgan CEMBI index is still up on the year, with a tightening in spreads witnessed across credit rating categories at the time of writing. This underscores the depth and breadth of a market that offers investors a highly diverse opportunity set.
The global economic outlook for 2022 looks relatively positive. As the global pandemic evolves into an endemic, the development of vaccines and new drugs to combat the virus should help the world return to a more normalised state, providing a somewhat positive backdrop for growth and activity. However, many facets of life have yet to return to normal, and the aftermath of the pandemic has left us with supply-chain disruption and shortages of resources, which are driving up inflation. While we expect inflationary pressure to ease over time, there is significant uncertainty over the timing of this and various driving forces look likely to remain in place over the medium term, as explained in the box below.
One source of supply-chain disruption that is driving inflation higher is the stop-start nature of economies reopening, given the pandemic. This phenomenon has the potential to persist over the short to medium term. In addition, the backlog associated with the shipping and container crisis is likely to take many months to unwind before it is resolved and inflationary pressures ease.
Another inflation driver over which there is limited visibility relates to labour markets. The shift in mindsets of workers who have chosen to leave the workforce post-pandemic has created inflationary pressures in wages and shortages of human capital. As time progresses, we could see a willingness of those who have left the workforce to return, but we have little visibility on this.
Finally, the rising momentum of government commitments to reducing carbon emissions has led to some inflationary pressures on energy costs, which have the potential to remain elevated as newer technologies take longer to ramp up and production of fossil fuels shrinks, leading to a supply/demand imbalance.
While we see a path for the bottlenecks outlined above to ease, the longer this takes and the longer uncertainty remains around the pace of both nominal and real growth, the higher the risk that inflation becomes entrenched. This uncertainty is making the US Federal Reserve reluctant to hike interest rates until there is more clarity around the extent and timing of these headwinds dissipating. Therefore, we think the risk of an abrupt hawkish shift by the Fed is limited.
That said, should the US economy return to full growth and the Fed become more confident about higher growth persisting, we would expect higher interest rates and higher yields across the entire fixed income world. In such an environment, we think the EM corporate debt universe – with its lower duration and higher spreads than developed market credit – offers compelling risk-adjusted return potential within the fixed income universe.
The above, coupled with the strong fundamentals of the asset class (described below), lead us to the view that the new year will herald a favourable environment from the perspective of EM corporate debt investors.
Considering new issuers from different countries around the world, we’ve been pleasantly surprised at how strong these companies have been over the past few years. Their earnings have been impressive and, if anything, their leverage has been coming down in a meaningful way. The trend of strengthening fundamentals continues.
More recently, company results have revealed a general picture of earnings returning to more normal levels after the record results in late 2020. This has helped leverage metrics fall back to 2015 levels. With high margins and strong earnings growth, many companies will enter 2022 on very solid foundations. In addition, the uncertain outlook is weighing on companies’ appetite for capital expenditure and expansion, reinforcing their ability to withstand future headwinds. This has led to many individual companies seeing their credit ratings upgraded. Coupled with low overall default rates, the result is a bondholder-friendly environment.
Considering the political landscape, the pandemic has shifted the political balance of many conversations. Governments across the globe are having to embrace more populist and left-leaning policies in response to demand from their constituents. This has already brought much headline risk in EM this year, and with it, asset price volatility as the political climate becomes less market friendly.
We expect this risk to remain elevated in 2022, particularly in Latin America where forthcoming elections are leading to rhetoric that undermines fiscal prudence. Elsewhere, in countries like Turkey external vulnerability remains high.
However, markets have absorbed much of this new risk already and we have seen both equity risk premia and corporate spreads widening, as policy-related headlines in countries such as Brazil and China led to volatility in corporate credit and equity markets. This repricing higher in pockets of the EM corporate debt universe has created attractive valuations for some companies’ bonds and increased the number of relative-value opportunities for active managers to seek to exploit in 2022.
We are looking to take advantage of the relative-value opportunities presented across the EM corporate credit market, focusing on medium-term fundamentals, and seeking out fundamental strength that is mispriced.
With this in mind, we see significant opportunities in China, as fears of a recession seem overblown and policy loosening already looks set to help mitigate macro headwinds. We see the most pronounced mispricing in China’s real estate sector and significant potential to capture alpha both from overweight exposure to the sector and positioning within it. We are also looking to capture widespread mispriced opportunities arising from the contagion to other sectors in China, particularly among BBB rated bonds.
Elsewhere, we remain overweight Latin America, specifically Brazil where we think risk premia are excessive relative to the fundamental strength of the companies we invest in. This mispricing is driven by concerns around Brazil’s deteriorating fiscal discipline and forthcoming elections. We have a particular focus on non-energy commodity companies, where we expect demand and prices to remain elevated.
From a sector perspective, we’ll be focusing on cyclical sectors, such as base metals, industrials and consumer, while remaining underweight financials due to their correlation to the macro and sovereign environment, which could be subject to negative political headlines. We remain underweight the oil sector, given the declining demand for fossil fuel investments and the sector’s typically long-duration (high sensitivity to rate rises) nature. In the same vein, we expect to increase our exposure to green bonds and cleaner companies that offer countries the chance to transition to a lower carbon footprint as we expect the demand for these bonds to remain very strong.
More generally, while we have been happy to own longer-duration bonds where curves are steep, we will look to hedge out interest rate risk if we see higher chances of interest rate hikes as we move into 2022. We will be looking to protect our strategies should we see risks of an overall shift to higher yields in the fixed income universe.
Overall, we will aim to deliver returns by adopting our usual approach to investing: taking a bottom-up perspective and searching for mispriced, fundamentally driven, value opportunities across yield curves, ratings and countries.
With Western central-bank policy normalising, economic growth rates diverging and global trade still readjusting to life after lockdown, investors have a complex environment to navigate in 2022.
Ninety One’s portfolio managers assess the outlook across their asset classes and regions.
Our team also takes a deep dive into the outlook for emerging markets, as well as into how sustainability will drive investment outcomes next year and beyond.