So, what are the potential tailwinds for the asset class? We think we could see two key drivers next year: a Fed pivot, and a China pivot. The market has now shifted its focus from if we will see these pivots, to when we will see them. We expect US rate hikes to continue, though at a slower pace, over a longer period than previously anticipated. We think this is largely priced in though, and therefore expect to see lower volatility coming from the “rate component” of the EMD asset class going forward. Meanwhile, in China, we have started to see some progress being made in terms of expansionary fiscal and monetary policy, though we think it’s unlikely we’ll see a material reopening before March 2023, which is when its new government officials take over.
In particular, we are positive about the outlook for Latin America. Within the region, inflation seems to have peaked, and we are already seeing some central banks coming to the end of their tightening cycles. Brazil and Mexico, for example, had already begun raising rates in the first half of 2021, well before the US. In addition, growth in the region is surprising on the upside; many countries have strong trade balances; and after a couple of years of uncertainty, we’ve come to the end of the political cycle too, with the largest countries there having held their elections recently. While the election outcomes have resulted in some left-wing or less market-friendly governments coming into power, damage in terms of fiscal expansion has so far been limited.
Elsewhere, we also like the Middle East. It is a clear beneficiary of the trend in oil and gas prices we’ve seen over the past two years, resulting in significant fiscal balance improvements in 2022, and we believe the positive effects are likely to benefit the region for years to come. While this is largely priced into energy companies’ bonds, we believe there are other areas of the market that offer more attractive valuations and could also benefit indirectly, like the real estate sector.
We’re finding some good opportunities in Africa too, particularly across bonds that are already trading at distressed levels, given how much sovereign bonds there have sold off. Even if some of these bonds were to default, we think it’s difficult to see the terms as being worse than what is already priced in.
Though there are sometimes misconceptions about the risks associated with investing in corporate EM debt, we think it’s interesting to note that excluding the idiosyncrasies of Russia, Ukraine, and China property developers, the rest of the high yield corporate bond universe is actually running at a default rate of 1.2%.1.
Furthermore, looking over the past 20 years, EM corporate debt only posted three years of negative returns (and it is set to post another year of negative returns for 2022).
While they’re offering historically high yields to maturity today, EM corporate bonds also tend to be much shorter duration compared to EM sovereign bonds, meaning that barring a default, as a significant part of the universe continuously goes to maturity, investors can realise the yield in a relatively short time span. Furthermore, by investing in corporate bonds, investors can position themselves in a more nuanced way than when investing in sovereign debt, as they can favour sectors with stronger tailwinds and try to avoid those that they think are likely to face headwinds, at a given point in the cycle.
Despite yields having risen across EMD, there are also some areas that require prudence, including the Chinese real estate sector. China’s official growth target of 5.5% looks out of reach, and policy decisions have had very little positive impact on the real estate sector to date. Nevertheless, we do think we could see some improvements in sentiment there.
There are also some risks related to refinancing. This year, we have seen the lowest levels of corporate and sovereign debt issuance in a decade. More positively, local markets have become much deeper, and we’re starting to see many issuers being able to refinance in local markets in their own currency, avoiding a mismatch between assets and liabilities. However, companies and sovereigns will need to access international markets to have a diversified funding base at a certain point.
In emerging markets, it’s not unusual to see knee-jerk reactions from investors, who often sell first, and ask questions later. But it is important to highlight that our investment universe encompasses 60 countries, both in investment grade and high yield debt. These countries might be at different points in the cycle and would not be impacted by the same events in the same way. Through differentiation, we can take advantage of this kind of indiscriminate selling to access many attractive investment opportunities, with strong fundamentals.
The value of active minds: independent thinking
A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.