Playing the long game in EMD

Read this article to understand:

• Why the recent sell-off in EMD could prove short-lived
• Why policy credibility has improved many poorer nations
• Some of the key opportunities and risks

Having endured a torrid time in 2022, emerging-market-debt (EMD) investors enjoyed a promising start to this year, fuelled by the prospects of a strong rebound in China and growing expectations interest rates in the United States and other developed countries were close to peaking as inflation began to subside.

Some of that optimism has begun to fade recently as it became clear US inflation was proving far harder to eradicate than many had anticipated, and as Chinese economic prospects dimmed.

However, Liam Spillane (LS), head of EMD at Aviva Investors, and Michael McGill (MM), senior EMD portfolio manager, argue that with US rates close to peaking, the outlook for total returns looks attractive, especially relative to developed-market debt. With many asset allocators still underweight EMD, they believe the relative credibility of EM policy stances strengthens the case for the asset class.

How would you describe sentiment towards EMD at the halfway point of 2023?

MM: At the start of the year most market participants were excited about the prospects for emerging markets. That was reflected in buoyant asset prices and healthy inflows into EMD. However, recent weeks have seen some of that optimism fade as it became clear US inflation was proving harder to eradicate than many envisaged, following well-publicised problems in the US banking sector, and as concerns about the pace of economic recovery in China mounted.

Nevertheless, we are almost certainly approaching the peak in US rates, which is a material factor for the outlook for fixed income. The fact an agreement has been reached to lift the US government debt ceiling and avert a potential default should also lend support to EMD.

We see opportunities for both government debt denominated in hard and local currencies, and corporate debt, given signs inflation is subsiding across a wide range of developed and emerging economies and relatively robust EM fundamentals. The prospect of central banks easing policy should help support investment flows into EMD, especially given many institutional investors remain underweight the asset class relative to history.

What is your assessment of the position EM countries find themselves in as the dust begins to settle following the pandemic?

LS: An observation that can be made about most of the mainstream EM countries is that their policy responses in the face of an unprecedented sequence of external shocks has been credible and very orthodox – in some cases even more so than those of developed nations. This point is often overlooked, but to think most EM countries could emerge from the pandemic, China’s zero-COVID policies, and the speed with which financial conditions have tightened without any systemic crises is testament to how far they have come from a policy perspective.

Central banks in EM countries proactively adjusted policy before their peers in developed nations given concerns about the non-transitory nature of inflation. They hiked rates early and aggressively to contain price pressures. The rise in real rates facilitated the adjustment of domestic and external imbalances that were needed to lower inflation. Meanwhile, the prudent management of foreign exchange reserves helped contain pressure on currencies.

Many countries are now pledging fiscal consolidation following an episode of widening deficits. With US rates close to peaking, macroeconomic headwinds are weakening. Although buffers need to be rebuilt, policy credibility has been boosted.

With much of the policy adjustment having already been made, and in many cases already reflected in valuations, the relative credibility of EM policy measures should feed into asset-allocation preferences. It is fair to assume that still needs to be factored into prices in some developed markets.

What presents the biggest threat to this optimistic picture?

LS: Around the turn of the year, there was a lot of optimism over the prospects for a strong rebound in China, which would potentially help offset weakening activity in the US and Europe. Given the sense of urgency on the part of Chinese policymakers to boost activity, we thought it likely China would have positive spillover effects on other EM economies.

To an extent that view played out over the last six months as investors favoured debt issued by commodity-exporting nations, the US dollar weakened and analysts significantly lifted forecasts for Chinese growth, even though traditional policy stimulus measures remained elusive.

However, that optimism is fading rapidly following a slew of weaker than expected Chinese economic reports. Now we have greater visibility on the general contours of domestic policy and the post zero-COVID policy world, it is becoming clear the recovery remains largely services led.

The sell-off in recent weeks is also explained by nagging concerns the US economy could be heading for recession. Although economic indicators have remained resilient, the full impact of past policy tightening by the Federal Reserve, and tighter credit conditions following the recent mini banking crisis, is unknown. While there is a lot of speculation the US could be heading for recession, this is not our central scenario. In any case, even if there were to be a recession, it would most likely be shallow.

As for China, policymakers need to be willing to utilise traditional policy levers. Although we anticipate the authorities will eventually respond to any material slowdown, concern over the strength of the response has in recent weeks led us to adopt a marginally more defensive stance in some portfolios.

While there is a risk emerging market assets will need to fall further in the near term, should that happen, it would present an opportunity for longer-term investors to increase their allocations to EMD. Following significant outflows from the asset class last year, we believe asset allocators remain underinvested.

Where do you see the most compelling opportunities?

MM: In the hard-currency universe, we like Nigeria and Gabon. Both have potentially positive catalysts. We expect Gabon to do a debt-for-nature swap in the coming months that will see around $500 million of its $2.5 billion debt stock refinanced. Gabon has a low default risk, as debt is on a declining trajectory given the country has been running budget surpluses and growth is recovering. The debt swap would further reduce near-term default risk.

As for Nigeria, we have confidence the country’s new president Bola Ahmed Tinubu will push through badly needed economic reforms, most notably the removal of a hugely expensive fuel subsidy that cost the equivalent of around three per cent of GDP last year. That would massively reduce the government’s net interest expense, one of the most talked about risks facing the country.

LS: Considering the EMD universe more broadly, local currency rates and duration appear to provide attractive prospective sources of long-term returns. We expect returns on local-currency debt to outperform those from developed markets. The high real rates of return on offer look attractive over a long-term horizon given credible and proactive policymaking. Returns should be driven by both capital appreciation and income.

In higher-yielding markets, Colombia, Indonesia and Mexico present good long-term opportunities in our view, while South Africa also offers value on a more tactical basis. We also like Poland and Peru and believe risk-adjusted returns are starting to look attractive in Asian bond markets on a currency-hedged basis. We have less conviction on emerging market currencies given risks to the global economy and prefer to look for relative-value strategies.

Where do you see the greatest risks at an individual country level?

LS: Turkey and South Africa are two countries where downside risks are potentially not fully priced. President Recep Tayyip Erdogan’s recent re-election snuffed out hopes for political change and the return of more orthodox policies. A significant amount of buying in recent months, as international investors looked to close out underweight positions, has left Turkish yields looking too low relative to peers. Foreign holdings of dollar-denominated debt have risen by around $6 billion since the fourth quarter of last year.

The central bank, having been protecting the lira, now has negative net reserves. Unless Erdogan adopts more orthodox policies quickly, credit rating agencies are likely to lower their ratings. We are underweight Turkish bonds in hard and local currencies.

Having suffered from political mismanagement for many years, South Africa faces increasingly stiff challenges. Problems with electricity generation are resulting in power outages of up to ten hours per day, crippling the country’s already anaemic growth.

Amid reports of corruption within public power utility Eskom, the South African grid does not generate enough electricity to match demand. As the country heads into winter, there is a non-negligible risk of a complete failure of the grid if large parts of the country experience very cold weather.

Having said this, some South African assets are beginning to look attractive, even if only on a tactical basis. In particular, local-currency bonds could potentially offer value, as interest rates may need to fall.

Which countries are at most risk of default, and do you see any prospect of China being brought into discussions with other international creditors?

MM: Although not a foregone conclusion, two countries at high risk of default are Pakistan and Egypt. Both are currently in discussions with the International Monetary Fund over the release of the next tranche of lending and delays have unnerved the market. Pakistan’s bonds are currently trading below recovery value.

While Egypt is trading near recovery value, if you consider the government is likely to pay coupons over the next year, current prices compensate you for the risk of default. If both countries push through needed reforms, they can still avoid default, which would present significant upside from current levels.

As for China’s stance, the news has been slightly more positive. For instance, in the case of Zambia’s debt restructuring, discussions with bilateral creditors appear to be making progress. However, China will be extremely reluctant to take principal haircuts, which could be a sticking point with other creditors.