Yields across hard currency emerging markets debt have blown out by 2% or more this year, with sovereign hard currency debt recording a YTD loss of almost -17%, driven mainly by higher interest rates across the globe.
Emerging markets now look extremely attractive relative to both their history and many other parts of fixed income. If past is any guide, from these valuation levels, EMD tends to deliver strong risk-adjusted returns. For many investors the difficult question is not just when to buy – but what to buy.
Inflation is putting pressure on central banks. Global growth is threatened by higher prices and tighter policy. The Russian invasion of Ukraine continues. China is struggling with lower growth and zero-covid policies. However, EM central banks are ahead of the curve in tackling inflation. Higher commodity prices are a tailwind for many. The presence of an emerging market middle class has made EM consumption less dependent on DM.
Energy-related inflation, as well as spikes in prices of basic materials, are usually perceived as positive factors for EM, but some countries are net energy importers. Wheat and other agricultural commodities can have significant effects on food importers.
In our team, we dig even deeper and ask ourselves questions such as:
– What might be the effect of higher prices at sector and company level?
– Can persistent inflationary pressures generate second-order effects on political stability?
Macroeconomic shocks rarely have the same impact on different countries and businesses: winners as well as losers emerge. This makes a selective approach essential for EM investors, creating a great environment for truly active managers.
Our team of EM credit analysts identify potential winners and losers:
LatAm – Alejandro di Bernardo
Mexico is a highly special case as its terms of trade are tied to the United States. While the country is a net importer, higher oil prices aid public finances via higher tax collections from state-owned PEMEX. Fiscal prudence should continue throughout the year and the opposition in Congress will likely limit radical changes. We thus stay overweight on selected utilities and names that can benefit from a reopening economy. Corporates are preferred to sovereign debt as relative spreads have meaningfully cheapened.
We are positive on Brazil. The country is a major exporter of iron ore and soft commodities (like soybean). On the political front, former president Lula has emerged as the favourite to win this year’s elections, and his alliances with centrist parties signal a more moderate approach. We stay tactically overweight on blue chip exporters, able to pass-through cost increases in the chemicals and metals & mining sectors. We see value also in some producers of fertilizers. Corporates are preferred to sovereign debt.
We maintain a positive view on Guatemala as the largest country in Central America with the lowest debt to GDP ratio in the region. The country maintains a prudent fiscal policy and thanks to record levels of remittances we expect higher growth for this year, despite inflationary pressures. We stay overweight on selective corporates with revenues in US dollars or with currency hedges, corporates preferred to sovereign on relative valuation.
Chile is a significant importer of oil and the increase in energy prices has been much larger than that experienced by copper, its key export commodity. Additionally, unlike 2021, we see limited room for the government to stimulate the economy, and ongoing constitutional reform adds political uncertainty. We are underweight across portfolios and prefer exposure to HY names in the Telecom sector given attractive valuations.
Peru is a net exporter of base metals, but we remain cautious. Ongoing political noise and risks of presidential impeachment make future prospects uncertain, and high copper prices might not produce expected improvements in the fiscal position of the country given inconsistent spending targets. We stay neutral to underweight and prefer exposure to selected miners and agricultural commodities exporters.
Asia – Xuchen Zhang
Indonesia is one of the few net commodity exporters in Asia, and will continue to see improving fiscal and external metrics, and robust GDP growth. The central bank has been consistent in keeping monetary policy pro-growth and inflation is under control. We like E&P companies that generate strong cash flows, as well as property developers that are set to benefit from improved household balance sheets. Nevertheless, allocations remain modest, as many corporates still carry significant exposure to thermal coal production, which does not help promote the transition to net zero.
• SEA – Philippines, Thailand, Vietnam
All three countries are net commodity importers and government balance sheets will deteriorate. In addition, the new Philippine government’s policy remains uncertain with regards to the local conglomerates that have issued the lion’s share of dollar bonds.
India sources c.85% of its oil and gas from imports: every $10 oil price increase leads to a 0.4% wider current account deficit and 0.5% higher inflation. Oil, metals and fertiliser together account for half of India’s imports, which is a heavy blow to both government and household finances. However, this also means renewable energy is more strategically important to the government as a sustainable solution. We continue to like this sector.
EMEA – Reza Karim
• South Africa
In addition to being a beneficiary of higher commodity prices and running a current account surplus for at least the next couple of years, monetary policy is credible and inflation is well managed. Commodity exporters in South Africa look particularly attractive.
• African oil exporters Nigeria/ Angola
Angola’s debt to GDP is expected to decline sharply because of the high oil price and the country is also almost self-sufficient when it comes to food imports. To a lesser extent Nigeria also benefits from high prices, but production has been running lower than expected and food inflation is high.
The IMF expects Kuwait, Oman, Qatar, Saudi Arabia, and the UAE to run large current account fiscal surpluses this year, thanks to oil. Strong fiscal surpluses allow much greater room to manage the increase in food prices through subsidies. The region is looking much stronger than the “Arab spring” period and the probability of political unrest is reduced.
As an energy importer, higher prices are clearly not a positive for its trade balance, and disruption to tourism from geopolitical events makes matters worse. Turkey remains though an idiosyncratic case. After a recent investment trip, we cannot see the ingredients for a default given a relatively acceptable Debt/GDP ratio and a sound banking sector. However, recent FX stability might not hold in the long-run unless the government can engineer new innovative schemes (such as recent tax-free TRY deposits). A potential government change in 2023 might be a positive for the country. We remain underweight, but watchful.
The country has large funding needs and access to foreign capital markets is effectively closed. Inflation is running high and so is its deficit. Without credible and strong macroprudential policy, it is hard to see stability anytime soon.
Despite the devaluation, the current account deficit and inflation remain high. Policy has been slow to meet IMF demands. Central bank policy is restricted as it is not possible to both fix the exchange rate and combat inflation at the same time. This implies more downside to bond pricing.
History tells us that yields at these levels are not sustained for the longer term in emerging market debt, and investors should consider returning to the asset class, or increasing exposure. At the same time, the consequences of higher inflation are crucial to the relative prospects of emerging market countries and companies, as such an active, selective approach is likely to deliver materially better performance.