Fundamentals returning into focus as fear recedes

Q What drove asset class returns in 2022?

All bond markets came under significant pressure in 2022, given the seismic shift in the inflation backdrop and monetary policy regime. In our outlook for 2022 we pointed to these as key sources of uncertainty for investors to navigate; reflecting back, it is hard to overstate just how severely they impacted financial markets.

Inflation soared as the post-COVID surge in demand met with disrupted supply chains. War in Ukraine dashed any hopes of this moderating, with food and energy market shocks intensifying inflationary pressure and forcing the US Federal Reserve (and many other central banks) on an aggressive path of interest rate hikes. While this buffeted bond markets the world over, the impact on emerging markets (EM) was especially harsh. Geopolitical factors – war in Ukraine and rising tensions between China and the US – took an additional toll on EM bond markets.

Q What trends have you seen in EM corporate bond issuance?

Within many of the EM companies in our investment universe, we typically find highly sophisticated treasury and finance departments. Over the past few years, these have taken advantage of low interest rates to issue bonds and secure ample finance for their operations. As the tide turned in 2022 and the cost of financing soared, this approach has proven highly prudent – many corporates have simply not needed to issue debt, with some actually buying back debt, resulting in negative issuance in 2022. We expect this trend to continue if market conditions remain challenging. Crucially for investors, a backdrop of limited supply could provide a useful support for the asset class once demand picks up.

QShould investors shun or embrace China?

In our outlook for 2022, we talked of our hopes for a loosening of policy in China. While there have been some encouraging steps, overall progress throughout the year in aggregate has been disappointing. Importantly for bond market performance, investors’ focus has remained fixed on policy developments, with no consideration of valuations, regardless of how dislocated they have become from underlying fundamentals. This has seen a swathe of offshore investors retreat from the market, driving prices for many corporate bonds to irrationally low levels. We think this presents some great valuation opportunities in 2023.

Furthermore, since the completion of the 20th Party Congress, we have observed a greater-than-expected divergence between the Chinese government’s stated position and the reality of the implementation of COVID restrictions. China’s leaders are travelling abroad again and welcoming foreign delegations to the country. China has also reduced inbound quarantine requirements and many cities and provinces have announced further local loosening. These tentative improvements have been well received by the markets and could potentially represent an important inflection point for China’s ‘zero-COVID’ policy, setting the scene more constructively for 2023. That said, the pathway is unlikely to be smooth as virus resurgences are inevitable, which will keep the narrative on COVID volatile.

Another important consideration for investors is that the direction of policy changes is also beginning to improve, with China showing a concerted effort to improve international relationships and smooth global trade. We also see significant efforts to improve domestic growth, with large-scale support now focused on China real estate, after a difficult 2022. The success of policies in addressing challenges in the sector will depend on how swiftly and resolutely they are implemented and executed across the country in 2023, with further patience required.

Q Are you enthusiastic about the overall outlook for 2023?

Absolutely. The dominance of macro drivers made 2022 a very testing year for our bottom-up, fundamentally driven value approach, but we are already seeing investors starting to pay more attention to valuations and how these stack up relative to underlying fundamentals. When the role of fear in investors’ decision-making retreats, we could see a tipping point and a shift to a more constructive phase in markets.

While signs of an end to the US rate-hiking cycle and positive developments relating to war in Ukraine will be key for a positive shift in sentiment, we think investors should already consider just how extreme valuations have become. Apart from during the Global Financial Crisis, yields have not been this high – or bond market valuations this low – for 20 years; we think the asset class offers excess stress premium for the fundamentals and risks.

Another key consideration for investors and something that fuels our optimism for the asset class is the strength of EM corporate fundamentals. While rising costs have weighed on companies’ profit margins, revenues remain resilient and leverage metrics manageable. All of this makes us excited about the year ahead.

Q Where will you focus your attention in 2023?

As bottom-up investors, we look for fundamental value opportunities across the investment universe. We will continue to take advantage of dislocations across credit markets by selectively rotating the portfolio. More broadly, an overarching theme for us has been to move up in quality (i.e., shifting the portfolio in favour of higher-rated bonds) without overly sacrificing yield.