Jun 30, 2022
On a recent visit to North America, Ninety One’s Emerging Market Debt portfolio managers and strategy leaders, Grant Webster, Werner Gey van Pittius and Peter Kent, spent time with allocators and consultants discussing the challenges and opportunities in the asset class. The conversations highlighted three questions that are top of mind for EM Debt investors.
Since the start of the year, we have been in a bond bear market with yields rising and credit spreads widening. While quantitative tightening and rate hikes have been key drivers, the war in Ukraine has exacerbated matters, not least by increasing inflationary pressure via food and energy prices. Despite all this, EM assets – excluding Russia, Ukraine and the underlying US asset price effects – have held up really well, with EM currencies outperforming G10 currencies. This reflects fundamental strength in many EM economies and the conservative approach of EM central banks, which moved decisively to tackle high inflation.
Over the past year, central banks across EM have acted much more prudently than their developed market peers by swiftly hiking rates. Much of the pain of rate hiking is already behind many emerging markets. With food and fuel inflation likely to moderate into year-end as the base effects of pre-crisis commodity price increases come through, we think most EM economies are on more favorable footing than developed markets. Historically, EM currency performance has been closely tied in with commodity cycles.
Furthermore – unlike in 2013 (taper tantrum) – strong terms of trade (average export prices minus import prices) have allowed emerging markets to run large current account surpluses. This meant monetary policymakers could cut interest rates during the COVID crisis without worrying too much about the negative impact on exchange rates. The subsequent surge in demand for EM exports (alongside sluggish imports) gave further support to EM current accounts. Now net lenders of US dollars to the rest of the world, emerging markets are more resilient to the negative effect on their exchange rates of US interest rate hikes.
The surge in commodity prices is widening the gap between commodity exporters and importers, with some emerging markets benefitting significantly. An increased focus on energy security is also likely to further boost a range of EM exporters of energy and materials needed for renewable energy. As for energy importers and other less fiscally robust economies, the allocation of special drawing rights from the IMF has substantially alleviated funding requirements in many markets. Furthermore, some energy importers (e.g., in Central and Eastern Europe and Asia) have very strong long-term productivity gains, balance sheets and external positions and, therefore, should see their assets remain resilient, despite the higher import costs.
The EM yield differential is still sizable, making the EM debt market a rich hunting ground for active investors, particularly given its inherent inefficiency. In the major EM bond indices, nominal yields range from 6.4% (corporate) to 7.5% (sovereign), which compares with a 3.0% yield on US sovereign debt (as at 31 May 2022). The difference in real yields is also stark, with a negative reading (-0.09%) in the US compared with 2.41% for the main EM local bond index.
While war in Ukraine and rising inflationary pressure saw the IMF revise down its growth forecasts, growth in emerging markets continues to outpace that of developed economies – with the gap expected to widen significantly in favor of emerging markets next year. Cyclical dynamics are also supportive of EM: as the US withdraws the exceptional policy support and its growth outlook weakens, we expect EM growth assets to outperform.
However, in bottom-up selection decisions, it is important to distinguish between structural and cyclical drivers; the consistent productivity gains seen in Asia and Central & Eastern Europe are structural, while current commodity price-related fiscal strength seen in Latin America and the Middle East & Africa is likely more cyclical in nature. That said, energy and commodity market trends may be moving into the realm of structural shifts when you consider the global transition to a net-zero world.
EM assets are cheap relative to history and to their developed market peers. Current valuations suggest that mild recession is already priced and that a hard recession (although not our base case) is not far off being priced. This suggests we could be nearing an attractive entry point; a turn in the inflation tide or another 100bps of spread widening are the triggers we are currently watching for.
But war in Ukraine and its implications for inflation and growth have complicated the landscape for the Federal Reserve and, consequently, for emerging markets. The peak in inflation has been pushed higher and further out, and the downside risks to global growth have been exacerbated. Our in-depth work on inflation and hiking cycles has made us relatively cautious from a top-down perspective, preferring bottom-up selection in a complex global environment, which we see as having distinct winners and losers.