The emerging markets debt (EMD) sovereign Index is down 17% year to date, while the corporate index is down 12%, about the same as US high yield, and outperforming US investment grade. The key driver of the sell-off is the US Treasury market which has been down 8%. So, the extra loss from EMD credit alone is around 4%, and that is despite the impact in emerging markets of the Russia-Ukraine war and volatility from the Chinese real estate market.
The EMD market has two components, the rate component and the EM credit risk component. If someone were to take the view that interest rates are close to stabilising, then now is the time to look at EMD. The main component of the current selloff has been interest rates rather than local risk.
Since the EM index started in 2000 there have been negative returns in only three years: 2008, 2013, 2018. In 2008, for example, the index was down 16%, and the year after it rose 35% and then next year it was up 13%. Markets can, and do, bounce back.
At current yields, we believe emerging market credit looks very attractive compared to history. The question is when to invest, and where? Risk-adjusted returns are historically strongest in corporate EMD, compared to sovereign and local currency debt. If an investor wants to take a long-term view and does not want to try to time the market, then EMD corporate is the most suitable allocation, in our view. Given the move in rates this year, higher-duration EMD sovereigns have the most potential to deliver short-term returns if one think there is going to be a change in both interest rates and EM sentiment.
In our strategy, the main thing we favour right now are inflation beneficiaries, asking ourselves which countries and corporates can benefit from higher prices. Brazil, for example, has companies that can benefit from inflation and higher commodity prices, and a central bank that is credible. We also like Angola because of the high oil price and the consequent positive impact on its debt to GDP ratio.
The biggest beneficiary of the current commodity shock is the Middle East, where budget deficits have improved massively, because of the oil industry. However, valuations are very expensive in our view, which limits our appetite for adding more exposure. In short, we are looking for countries that are beneficiaries of inflation but where it’s not already priced in.
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