Outlook 2023: Why 2023 could be a good year for emerging market debt
Outlook 2023: Why 2023 could be a good year for emerging market debt
Following a particularly difficult year for fixed income, Alejandro Arevalo and Reza Karim explain why there are reasons to be positive about the outlook for EMD.
It’s been a particularly challenging year for fixed income assets as a whole, including emerging market debt (EMD). Rising US rates, the war in Ukraine and macro uncertainty in China have all contributed to a particularly turbulent market environment. However, while we acknowledge that there remains a lot of uncertainty around these headwinds, we do believe there are many reasons to be positive about the outlook for EMD as we move into 2023.
High yields, without excessive risk
Given widespread sell-offs across EMD, yields have risen sharply across the board. With such high yields now available across the asset class, investors can find attractive entry points even when investing in more defensive areas of the EM universe. Solid countries and businesses with limited risk of default are offering some great opportunities to realise compelling returns over the cycle. Fundamentals are generally looking strong, and have actually improved over recent years, though spreads are not reflecting this – something which is not unusual for EMD.
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.
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.
Areas we like: Latin America and the Middle East
While there’s been a lot of focus on the US and the latest moves from the Fed, there are many positive developments at the local level in emerging markets which shouldn’t be ignored.
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.
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.
The benefits of corporate bonds
While we believe there are attractive opportunities available across the full spectrum of EMD – across both corporate bonds and sovereign bonds (hard and local currency debt) – we are currently finding the most value in the corporate bond space.
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.
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.
Staying mindful of the risks
While we are positive about the outlook for the broad EMD asset class, we always remain mindful of the risks. There is still significant uncertainty about developments regarding Russia’s invasion of Ukraine, and we expect to see ongoing tensions between the US and China. We believe, however, that a dynamic and pro-active investment process can help us to mitigate those risks as they arise.
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.
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.
Taking advantage of indiscriminate sell-offs
No one can know with certainty when it’s the bottom of the market, and we are not going to try to make those kinds of calls. A deeper-than-expected recession in the US would hit sentiment and likely result in a sharp sell-off in risk assets, for example. However, investing with a longer time horizon does allow fundamentals to come into effect. A combination of low valuations and strong fundamentals, along with several potential tailwinds, means that some areas of the market are looking particularly attractive to us right now.
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.
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.
Risks
When investing in developing geographical areas there is a greater risk of volatility due to political and economic change; fees and expenses tend to be higher than in western markets. These markets are typically less liquid, with trading and settlement systems that are generally less reliable than in developed markets, which may result in large price movements or losses to the investment. Low rated bonds or bonds that are not rated by a credit rating agency including high yield and distressed bonds may offer a higher income, but the interest paid on them and their capital value is at greater risk of not being repaid, particularly during periods of changing market conditions.
1 2022 YTD as of end of October ‘22. Source: JPM.
Outlook 2023: Navigating a new world
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