A typical question that asset allocators have posed in recent months is whether a ‘US Treasury+ spread’ asset class such as emerging market (EM) hard currency sovereign debt warrants a place in their portfolio, particularly in an environment of heightened economic and political uncertainty. Here are three reasons why we think it does, and why now is a good entry point
- Cyclical and structural tailwinds bode well – both for the macro dynamics in many emerging markets and for the return outlook of the asset class.
- The increasing diversity in this often under-researched, uncrowded investment universe creates alpha-capture potential that’s hard to match.
- Thanks to prudent policymaking, EM economies have increased their resilience and are leading the rest of the world when it comes to reducing debt vulnerabilities.
We also share insights into how best to navigate the asset class and pitfalls to avoid in portfolio construction.
Chapters
Reason one: Asset-class tailwinds
Spreads and the Fed
After several false dawns, the turn in the US interest cycle is finally in sight. Crucially for investors in emerging market (EM) hard currency debt, that portends well for asset-class returns. History has shown that following periods when US Treasury yields peaked, the 12-month forward return was historically higher in the EM market than in the US high-yield market.
Figure 1: Average 12-month return after 5-year US Treasury yields reach 3.5% to 4.5%
| Asset class | 12-month forward return potential* | Current duration | Current yield |
| US high yield | 6.0% | 3.3 years | 7.9% |
| EM hard currency sovereign debt | 8.9% | 6.5 years | 8.4% |
Past performance does not predict future returns; losses may be made.
Source: Ninety One and Bloomberg, analysis range January 2003 – March 2024, US HY uses BofA Indices, EM Sov uses JP Morgan EMBI GD.
*Historical average 12-month return after 5-year US Treasury yields reach 3.5% to 4.5%. Duration and current yield is at June 2024.
Furthermore, current spread levels are supportive of the return outlook. While spreads in the EM hard currency sovereign debt universe are still wide relative to their 10-year history, in the US high-yield market they are close to the tightest they have been in the last decade (Fig. 2). In the context of the significant upside surprises seen in EM economic growth data in the first half of 2024 and differentiated progress on disinflation, we believe EM credit spreads should remain resilient, provided the US economy continues to avoid a hard landing (as is our base case expectation).
Figure 2: Current spreads relative to 10-year history (percentile rank)
Source: JPMorgan, Ninety One calculations, as at 28 June 2024.
Structural shifts
From a more structural perspective, many EM economies are benefitting from the changing trading relationships emanating from political change. As developed and emerging countries pursue their national interests, new spheres of influence are forming, reshaping the global landscape, with profound implications for globalisation, economic policies, currency and commodity valuations, and geopolitics. The transition to this multipolar landscape is being marked by increased geopolitical tensions, conflicts, and a more complex and fragmented global order. Simultaneously, an increasing number of countries, particularly in the so-called Global South, have chosen to remain non-aligned, unwilling to be pawns in a larger geopolitical game.
What does this mean for emerging markets? Winners will be those countries that diversify their economies, build strong regional alliances, and can navigate between different global powers. For example, countries in Central and South America such as Mexico and Costa Rica have benefitted as US companies build manufacturing operations nearer to home. Similarly, India has benefitted as companies like Apple, following the COVID triggered supply chain crisis, has implemented a plan to ship 40% to 45% of iPhones from India, compared to a single-digit percentage in 20221. Conversely, those heavily reliant on a single economic partner or resource, or those isolated internationally, might face challenges.
This is likely to lead to further differentiation in economic prospects among the growing number of countries in the EM hard currency debt universe, a wider dispersion of returns, and greater opportunities for active managers.
1 Wall Street Journal, November 2022.
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. Emerging market: 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.
