Emerging Market Debt Indicator August 2023
In the latest edition, the EM Debt team provides an update across the investment universe and shares the latest outlook and current top-down positioning.
27 Nov 2023
It was a strong start to the year for the emerging market (EM) debt asset class, with local currency debt the star performer and all areas of the EM debt market delivering a decent performance. The middle of the year marked a change in the composition of returns, with some of the earlier performance being given back, but returns remained in positive territory for the year. The driver of this mid-year shift was US growth proving to be more resilient than expected and Europe and China’s growth underperforming, which is a negative mix for emerging markets.
But within EMs there has been plenty of diversity. Economies whose central banks carried out painful but necessary rate hiking relatively early to get on top of inflation (e.g., Latin America) have seen their local bond markets outperform. In contrast, Asian markets – where monetary policy tightening was less pronounced – have underperformed.
It now looks like inflation is going to ease – either (as we expect) through weaker growth dynamics or through continued action by central banks. That, coupled with cheap valuations – especially in EMs – leads us to think that 2024 will be a good year to invest in bonds.
Within the asset class, investors have a broad choice between higher-rated markets that would perform well in the event of a recession, and high-yield markets that are more cyclical and tend to perform well when growth improves. The growth picture does seem to be improving. China is providing more support to its economy to improve the outlook there. The global manufacturing cycle, which struggled in 2023 and weighed on growth rates, is improving. While overall growth will remain softer, it should be more evenly spread across economic segments and regions. This firmer overall backdrop is favourable for EM fixed income, in our view. But risks remain around growth, inflation and heightened geopolitical tension. This means flexibility to adjust positioning and a bottom-up focus are important.
We expect EM currencies to continue to behave relatively well overall, thanks to the orthodox policymaking by the majority of EM central banks and the fact that EMs have spent the last decade strengthening their economies following the taper tantrum. We discuss this in more detail here.
But a bottom-up approach will be really important in a year when some central banks will be cutting rates and others will still need to be hiking, and where some economies will be more resilient than others.
Sustainability, always important in EM, is continuing to move to the forefront of EM debt investors’ minds, underscoring the importance of fully integrating this into investment decisions.
In 2023, a renewed sense of urgency around the energy transition and climate risks saw significant activity among emerging markets in the sustainable bond issuance space. This looks set to continue and transition finance is likely to be a dominant focus here.
On the local currency debt side, we think Brazil is an interesting market to consider. Brazil has been a leader on the global stage in terms of its early hiking cycle and has run very high real (inflation-adjusted) policy rates. It is now positioned well for further rate cutting.
On the hard currency debt side, rather than looking through a regional lens, we think it will be more useful to consider the investment universe in terms of rating buckets. Given the risks around recession and inflation, we are thinking in terms of a barbell approach: among lower-quality markets, we’re focusing on well-valued markets e.g., distressed debt markets that will be relatively immune to global macro developments; while at the higher-quality end of the spectrum, we are seeking out more defensive areas that are still relatively cheap (i.e., at the lower end of the investment-grade spectrum).
General risks. 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. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.
Specific risks. Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses leading to large changes in value and potentially large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates rise. Emerging market (inc. China): 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.