Bucking the trend

Read this article to understand:

• Why emerging-market debt has been holding up so well in the face of the trade war.
• Why strong fundamentals should continue to lend support to the asset class.
• Why investors, if they have not already, should consider adding emerging-market debt to their fixed-income allocation.

The seemingly unpredictable nature of US President Donald Trump’s decision-making has unnerved financial markets. A volatile US policy backdrop has translated into volatile markets. Sentiment has shifted between extreme concern about the possibility of an imminent US recession to a much more sanguine view that a trade war can be averted.

Against this backdrop, traditional safe havens such as the Swiss franc and gold have, unsurprisingly, been in demand.

Few other asset classes have offered investors sanctuary. But one notable exception has been emerging-market debt (EMD). EMD denominated in local currencies has performed strongly, as of May 7 returning 8.2 per cent year-to-date.

Meanwhile, EM hard-currency debt has performed far better than might have been expected judging by other similar risk-off episodes. It has only marginally underperformed US Treasuries, reinforcing the market’s belief this is an increasingly resilient asset class.

American exceptionalism gets turned on its head

That EM bonds have fared so well may come as a surprise to some. After all, Donald Trump’s election victory was widely tipped to provide a fresh shot in the arm to ‘American exceptionalism’. Emerging-market economies, on the other hand, were seen as among the most vulnerable to the threat of a global trade war, especially given expectations the US dollar would strengthen.

Just four months into the year those ideas are being turned on their head. The International Monetary Fund (IMF) recently predicted global growth would be just 2.8 per cent this year, half a percentage point lower than it had forecast only three months earlier. Next year would be only marginally better.

But whereas it was once assumed most of the adverse impact of any US tariffs would fall disproportionately on its trading partners, it now appears the US itself will bear the brunt of the cost.

The IMF believes the US economy will now grow just 1.8 per cent this year, a third lower than its January estimate. It also shaved 0.5 percentage points off the aggregate EM growth forecast, though this was predominantly driven by downgrades to China and to countries most exposed to US tariffs, like Mexico, or to lower oil prices like Saudi Arabia. Revisions to the bulk of emerging-market nations’ growth forecasts were minor, indicating they are expected to emerge from a trade war comparatively unscathed.

EMD’s growing resilience

That EMD is riding out the current storm should not come as a total surprise to those familiar with the asset class. After all, it has had to contend with other big shocks in recent years, most notably from the pandemic, and the high levels of inflation that followed Russia’s 2022 invasion of Ukraine and the associated global tightening of financial conditions. It weathered both shocks relatively well.

As for the present situation, inflation is declining in most countries. This should enable central banks to continue lowering policy rates, especially were the dollar to remain under pressure. Current accounts are generally healthy too, allowing authorities to build-up foreign exchange reserves. Fiscal performance has been more mixed, with some countries struggling to keep deficits under control, but lower interest rates and easier global financial conditions should help even the most vulnerable in this task.

While the risk of a global recession cannot be entirely discounted, the likelihood is that emerging-market nations will in the main continue to post respectable growth. Export prospects may have become more uncertain, but strong domestic demand and robust wage growth are supporting activity in the case of most bigger emerging-market economies. Meanwhile, a slowdown in China is not expected to be severe enough to push commodity prices materially lower. As a result, EM economies are projected to continue to grow faster than their developed market counterparts.

We have developed a model which assigns a rating to each country based on a variety of factors. We recently used it to compare different EM countries with their DM peers. Unsurprisingly, the latter group rated higher. However, much of this differential came down to factors like total GDP, GDP per capita, and governance.

While these factors are important, as they can help buttress a country against economic shocks, they are comparatively static. As such, they are less likely to impact bond prices than more cyclical components of the rating, such as rates of economic growth and inflation and the size of public sector deficits and the state of external finances.

What is interesting is that many DMs appear just as vulnerable on these yardsticks as riskier segments of the EM universe. The chart below shows different countries’ ratings in terms of both structural and cyclical factors. It highlights that while DM countries tend to be stronger in a structural sense, having high per capita income and larger economies, there is little difference when it comes to cyclical factors like budget deficits and growth. The likes of the US and UK are in a broadly comparable position to Romania, a country that is at risk of losing its investment-grade rating.  

In a sweet spot

As for EMD denominated in local currencies, it finds itself in a sweet spot, buffered both by inflation rates that are under control and a weaker US dollar.

As shown in Figure 3, total unhedged returns in EM local currencies so far this year can be attributed in almost equal measure to falling yields (rates returns) and appreciating currencies (FX returns).  

Indeed, the decline in the value of the dollar, coupled with the likelihood Chinese exporters will be forced to lower their prices as they search for new homes for their products, should enable inflation to fall further. That should in turn allow central banks to cut interest rates from what are elevated levels in real terms, without having to worry about currency weakness.

EMD opportunities are not confined to sovereign issuers. Corporate bonds offer investors a means of boosting returns while further expanding the diversification of their exposure to emerging markets, thereby potentially increasing the resilience of their portfolio.

Issuers operate across multiple business sectors and hail from a variety of countries. They range from quasi state-owned corporations to publicly listed enterprises and privately owned businesses. In some cases, these companies are national champions while in others they are global leaders in their respective fields. The opportunity set also contains special purpose vehicles. Ratings range from investment grade to high yield.

Uncertainty stemming from the outlook for global trade, and with it the global economy, coupled with the diversity of the opportunity set, is arguably providing a fertile ground for active management at present.

Within our portfolios, for instance, we have been looking to get exposure to companies we believe will prove resilient in the face of tariffs, slowing economic growth, big currency fluctuations, and sizeable moves in interest rates.

As ever with emerging markets, investors need to be alert to the fact this is not a homogenous asset class. As the IMF acknowledges, some countries, such as Mexico, that depend heavily on the US as an export destination, are likely to be badly affected. President Trump’s tariffs are expected to shrink the Mexican economy by as much as 1.8 percentage points this year, which would be enough to send it into recession.

Romania and Colombia, both of which are running sizeable twin deficits, could also be badly affected in the event trade tensions lead to a tightening of global financial conditions, preventing their central banks from lowering interest rates, at the same time as economic growth cools.

A diverse universe

But the diversity of the asset class is one of its key strengths. Containing investment-grade and sub-investment grade sovereign debt, corporate debt, and bonds denominated in hard and local currencies, investors have a multitude of investments to choose from.

Of the 70 countries in our sovereign debt universe, we have a positive view on 32. These are not confined to a single region, nor are they all commodity producers, or restricted to investment-grade issuers. For instance, we have a positive outlook on Oman, Morocco, Guatemala and Azerbaijan. With relatively low debt, a commitment to reform, and credible economic policy, we believe these four countries are on course for an investment-grade rating.

Egypt, Pakistan and Sri Lanka are three other nations where reforms and fiscal consolidation potentially put their credit rating on an improving trajectory.

As with every other asset class, investing in EMD does not come without risks. Prominent among them at present is the danger the current trade war between the US and China escalates, prompting a material slowdown in global economic activity.

But as this year’s rally shows, EMD is capable of withstanding such global economic shocks. Offering an opportunity to enhance yields and diversify global fixed-income portfolios, the favourable fundamental backdrop should ensure this underappreciated asset class attracts a growing fan base.