Emerging markets have remained robust amid the economic and political uncertainties of 2024, but active management will be important if debt investors are to identify standout performers over the coming months.
Read this article to understand:
- Why emerging-market debt is in a strong position to deliver resilient returns for investors.
- Why selective high-yield issuers look to be especially appealing.
- What we assess to be the main risks facing the asset class
Emerging-market (EM) debt encompasses a vast range of countries, from global powerhouses such as China and Brazil to smaller, dynamic economies in Southeast Asia and Sub-Saharan Africa.
Nevertheless, EM nations tend to share certain characteristics – such as relatively stronger growth, lower debt and more-favourable demographics than advanced economies – and it is often possible to spot common trends developing across the broad EM universe.
EM debt looks to be in something of a sweet spot. Many EM debt issuers have demonstrated resilience in the face of significant geopolitical and macroeconomic uncertainty this year. And we see several reasons to expect more of the same over the coming months.
For instance, a number of major EM nations have improved their fiscal balances and successfully tamed inflation since 2022. And broader macroeconomic conditions are also becoming more propitious. US inflation is trending lower, increasing the likelihood the Federal Reserve (Fed) will begin cutting rates later this year, perhaps as soon as September. This could encourage global capital to start flowing towards EM economies where rates remain higher. At the same time, US and global economic growth is holding up, confounding the expectations of some economists that 2024 would see a “hard landing”; this could benefit EM countries that depend on exports.
While EM investment-grade spreads are tight relative to US Treasuries, in most cases this is justified by strong EM fundamentals. That means yields remain attractive, in our view. EM high-yield debt offers the potential for outsized returns, so long as the global economy continues growing at a reasonably healthy pace.
Nevertheless, even as supportive dynamics are in place across the broad EM category, there are signs that we may be about to see greater dispersion within it. In this context, the ability to analyse the fiscal dynamics of individual issuers, assess how they will fare under different economic scenarios and account for the impact of domestic political developments will all be increasingly important, as will active security selection.
In this Q&A, fund manager Michael McGill (MM) and analysts Carmen Altenkirch (CA) and Nafez Zouk (NZ) offer their outlook for the second half of the year, potential developments that might surprise markets, and how they are looking to position their portfolios.
Where do you see the most value in EM debt at present?
CA: With investment-grade EM debt spreads over US Treasuries tight by historical standards, selective high-yield issuers appear to offer most value. We like bonds issued by the likes of Ecuador, Egypt and Argentina, three governments that continue to demonstrate a commitment to getting deficits under control.
Many of the other less-highly rated nations have also made big strides in strengthening their public finances. Although headline fiscal balances are in many cases still quite high, this is primarily due to higher interest costs. Primary balances, which strip out these costs, are in many cases back to where they stood prior to the COVID-19 pandemic, which is quite an achievement on the part of those countries.
Some EM nations have benefitted from higher commodity prices, which has led to a narrowing of current account deficits, particularly in Sub-Saharan Africa. Then again, should commodity prices weaken, high-yield and more distressed issuers could be vulnerable.
NZ: In local-currency markets, we think there is value in countries where credible monetary policy is creating a supportive growth-inflation mix for bond returns, such as in India, Turkey and Poland.
While disinflation remains on track in many emerging-market countries, those which have kept fiscal deficits under control or have stepped up efforts to get them under control could outperform their peers. We see added value in unhedged exposure in markets such as India and Turkey, where currencies should be supported by central banks which are looking to build their reserves, and in other cases via improving trade balances as a result of higher commodity prices.
Where could risks emerge?
MM: Within the more highly rated segments of the EM universe, we could see greater return dispersion. Countries willing to undertake further fiscal consolidation to offset the potential impact of higher rates or slowing revenue could outperform those that continue to run wider deficits. The likes of Brazil, Colombia and South Africa are most at risk, given the unfavourable starting point of their debt dynamics.
While EM central banks look to be close to winning their battle to tame inflation, rates remain uncomfortably high. Higher rates not only mean higher debt-servicing costs but potentially weaker economic growth as well, a potentially dangerous combination.
NZ: This year has seen plenty of elections (South Africa, Mexico and Indonesia to name a few), while Romania, Hungary, Brazil and Ghana are also due to hold votes in the second half. Governments tend to find it difficult to commit to fiscal consolidation around elections, meaning countries in weaker positions are likely to face increased scrutiny.
India, Chile, Poland and the Philippines are examples of countries which should deliver sufficient economic growth to withstand pressures.
What are the key macroeconomic themes you are monitoring?
MM: Over the past six months or more, investors have focused intently on the path of US inflation and the Fed’s ability to engineer a soft landing after it was forced to put rates up to their highest level in more than two decades. We don’t anticipate this focus changing, although we see two additional factors that are key for EM bond returns.
The first will be US economic growth. Until now, the focus on whether the Fed was getting inflation under control meant very few people were concerned about the impact higher rates would have on growth. We believe the growth side of the equation will now garner more interest. Financial markets are expecting a “soft landing”, but we see a danger growth slows faster than anticipated.
The second factor is the outcome of the US election. It could have wider implications for the macroeconomic environment and geopolitics, both of which are important factors from the EM debt market’s perspective.
It is too soon to have a strong view on specific implications for emerging markets. But US national debt is currently growing at $1 trillion every 100 days, and regardless of who wins the election, the pace of the increase could accelerate. In that event, long-end US bond yields would likely remain elevated, which could be bad news for EM debt denominated in both local and hard currencies.
What have you learnt from this year’s elections so far?
CA: We continue to observe a strong willingness by electorates to punish governments adjudged to have mismanaged the economy, and reward those that have successfully delivered on their promises.
South Africa is a great example. Its bonds rose after the ruling African National Congress (ANC) lost its majority at the general election in May and was forced into an alliance with other parties. Bonds rallied because investors believe policymaking will improve as a result.
NZ: Mexican debt, by contrast, sold off after the ruling Morena party won a majority in Mexico’s general election in June. That sparked concerns it could look to undermine the judiciary and other key institutions, such as the country’s independent central bank..
In the Indian general election, which concluded on June 1, Prime Minister Narendra Modi’s ruling Bharatiya Janata Party (BJP) fell far short of winning the majority that had been widely expected, forcing it to rely on smaller allies for support. The outcome of the vote reflects a perception Modi had not focused enough on job creation and had pandered to the business elite, despite successfully lifting millions out of poverty during his time in office over the last decade. Nevertheless, with few near-term implications for economic policy, the market looked through the results.
Are there any other elections you will be focusing on?
MM: During the remainder of 2024, Ghana and Sri Lanka are set to go the polls. With debt restructurings due to be completed over the summer, investors will be hoping fiscally prudent governments are elected. Fiscal risks will also be front of mind around Romania’s elections later this year and Brazil’s local elections in October. And looking further ahead, investors will also need to be alert to the danger that governments in Peru, Colombia, Hungary and Poland may loosen the purse strings in 2025 ahead of elections.
Correctly anticipating how bond markets are going to react to election results is far from straightforward, as is predicting the election result itself, given the unreliability of opinion polls.
So how can investors ensure their portfolios are resilient faced with political uncertainty?
CA: Geopolitics should be given more weight in the investment process. Understanding the implications of shifting power dynamics, and what these mean for a country’s relative performance, politics and policy choices is an important determinant of assessing both risk and reward.
The geopolitical landscape is changing, and assumptions of the past may no longer hold. This is not just about conflict, it is about shifts in capital that could have profound effects on bond markets. For example, the United Arab Emirates (UAE) said in February it would invest $35 billion in developing real estate in Egypt’s Mediterranean coast.1 This was a high-profile example of a country effectively bailing out a neighbour and it prompted Egyptian debt to soar, showing that it is important to monitor these kinds of political alliances.
There are also signs countries are increasingly looking to transact trading arrangements in their own currencies and not the US dollar: consider India’s recent rupee payment for oil to the UAE. And an increasing number of central banks are opting to hold reserves in non-dollar assets such as gold. The rise of nationalism is changing trade dynamics, and makes the world more complex and volatile, and therefore harder to predict.
We believe these developments favour an active investment approach. Bond indices naturally tend to be heavily skewed towards the most indebted countries or firms. But in a rapidly changing world there is no guarantee a country or company that has been highly rated in the past will remain so. Some of those which have issued large amounts of debt at cheap rates of interest could find themselves in trouble. Conversely, smaller countries offering attractive yields may be well placed to benefit from increased demand for gold or shifts in regional alliances.
Which EM issuers do you have a positive outlook on?
NZ: We remain positive on India given the strength of the country’s economy and its policymaking institutions. A structurally improved balance of payments position and the recent inclusion of Indian bonds into international bond indices should lend support to Indian debt prices in coming months.
While the election result cast a cloud over the market, we do not envisage any dramatic policy shifts in the near-term, as evidenced by Modi’s recent decision to keep key ministers in their posts. That said, given the scale of the electoral setback, the BJP-led coalition will have to acknowledge the source of electoral discontent. That is likely to translate into a greater focus on welfare transfers to lower-income groups and the scaling up of support programmes. For now, however, there appears to be room to accommodate higher transfer spending without jeopardising envisaged fiscal consolidation.
Poland is another country with a vibrant economy. Debt prices should be lent further support by the ongoing structural improvement in the country’s trade balance, and political developments after the country last year shifted to the centre ground and away from the populist right.
While the country’s deficit remains high after soaring during the pandemic, healthy economic growth and the fact Poland can access significant EU funding should enable the government to comfortably finance it. Turkish debt also looks attractive as the country’s pivot back towards macroeconomic orthodoxy continues to pay dividends.
On the other hand, Indonesia and Peru are two markets where risks are worth closely monitoring even if their fiscal metrics look healthy at present. In the case of the former, the currency has been under pressure as a result of a worsening trade performance and this could pose a threat to the country’s bonds. As for Peru, ongoing political instability threatens to adversely impact economic growth, potentially complicating the government’s efforts to balance its books.
Footnotes:
1 Patrick Werr and Karin Strohecker, “Egypt announces $35 billion UAE investment on Mediterranean coast”, Reuters, February 23, 2024
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