The current global environment is undoubtedly problematic for emerging market debt (EMD). As of 3 November, the US Federal Reserve (Fed) had hiked US interest rates by a remarkable 375 basis points (bps) since just mid-March. With most other countries also aggressively raising rates to combat high inflation, the result has been slowing global growth and markedly tighter global liquidity conditions. Adding further to the negative mix have been the soaring US dollar, the Ukraine war and struggling Chinese economy.
Despite all this, however, some important countervailing factors lead us to believe that the risk/reward balance is now attractive for EMD. Indeed, four key factors indicate to us that after the brutal sell-off of 2022, EMD could now be offering a potentially once-in-a-generation investment opportunity.
1. Historically attractive yields
In all asset markets, investors rationally prefer to buy whenever valuations are attractive. In the bond market context, arguably the single most important valuation measure is the yield level. The history of EM bond markets shows that it’s always preferable to buy at historically elevated yields. This makes sense because with higher yields the starting level of recurring income (from coupon payments) is high and there’s greater potential for price appreciation whenever yields revert lower over time. More defensively, in the event of prices staying weak, a sizeable income component can have a cushioning impact for total returns.
As shown below, the end-October index yield of 9.66% for hard currency sovereign EM bonds1 was 437 basis points (bps) higher than at end-2021, and far above the 20-year average of 6.43%. For comparison, during the period of heightened pandemic uncertainty, the index yield peaked at 7.99% on 19 March 2020. Those recognising value around this time and investing would have been richly rewarded2 – by early August 2020, the yield had normalised to less than 5%, giving a total period return of 26%.
Emerging market debt yields since 2010
Source: Bloomberg, November 2022; Past performance is not a guide to future performance
Yields in the other segments of EMD are similarly dislocated at present, suggesting potentially attractive entry points. In the case of local currency sovereign bonds3, the end-October index yield of 7.43% was 171bps higher than at end-2021, and above the 20-year average of 6.51%. For EM corporates4, the end-October yield of 8.53% was 395bps higher than at end-2021, and far above the 20-year average of 6.13%.
2. Inflation close to peaking
“…in most EM countries, inflation now appears close to peaking, and should move to a sustainably lower trend path as the lagged impact of past rate hikes comes through.”
It is worth remembering that the key driver of higher interest rates and government bond yields everywhere has been unusually high and rising inflation. However, in most EM countries, inflation now appears close to peaking, and should move to a sustainably lower trend path as the lagged impact of past rate hikes comes through. As more evidence for this emerges, central banks should be able to first pause tightening and then eventually begin easing policy to support growth.
In the case of the US, current market expectations suggest the Fed should complete hiking rates before the end of H1 of 2023, with a peak Fed Funds Rate of around 5%. Importantly, since this is substantially baked into current elevated US Treasury yields, the scope for continued negative impetus to EM bonds from here seems much more limited. On the contrary, the impact could easily become positive depending on how quickly the Fed ‘pivots’ to a more growth-supportive policy path. Furthermore, any pivot could also help ease the headwind of US dollar strength.
3. Supportive supply-side picture
On the technical side, the supply picture for EMD is now highly supportive. Owing to market conditions, sovereign and corporate issuance in the first nine months of 2022 was USD352 billion (bn), a huge decline compared to USD724bn in the whole of 2021. Additionally, many issuers are choosing to retire outstanding bonds rather than refinance at less attractive rates. As a result, JP Morgan is forecasting that combined EM sovereign and EM corporate foreign currency bond new issuance will be negative this year to the tune of around USD102bn.5
All else equal, a reduced supply of bonds should act as a downforce for yields. For professional investors, the ‘buyers’ market’ environment should also be conducive for attractive new issuance premiums.
4. Comparatively good economic fundamentals
In terms of fundamentals, weaker growth conditions are bound to have a negative impact in terms of tax revenues and EM corporate earnings, as well as default rates. However, in many cases, the expected growth shock from higher rates will be much less than for developed markets (DMs). For example, in its October World Economic Outlook6, the IMF forecast that 2023 ‘EM and Developing Economies’ growth of 3.7% will be a full percentage point higher than for ‘Advanced Economies’.
At the same time, recent fiscal and public debt dynamics of many EM countries seem less problematic than in developed counterparts, helped in part by more restrained pandemic-related spending. This is broadly true in the corporate context too, where EM companies’ leverage relative to similarly rated developed market companies is around 1 to 2 times lower in aggregate.
Final thoughts – the importance of selectivity
While the overall risk/reward balance now looks quite compelling for EMD, we also think the current environment strongly reinforces the need for investing selectivity. This is because each country or issuer is unique, with differential exposure to key risk factors. More broadly, we think that careful country and credit selection increases in importance in weaker growth environments. This includes with respect to the critical aim of avoiding potential ‘value traps’ – those cases where higher bond yields may not be compensating for the totality of risks.