The outlook for emerging market debt has improved strongly following China’s re-opening, in our view.

The growth rate in China will be supported by the $4.8trn of savings amassed by the Chinese consumer during the Covid lockdown and is expected to increase significantly in the coming quarters. While recessionary risk in the US is a concern, there is a high degree of confidence about higher growth in China, which means that China is likely to be the engine of global growth once again. Emerging market debt (EMD) is the most obvious asset class to benefit from this. The asset class is likely to be further supported by rangebound US Treasuries yields. This has created a strong appetite for EMD, as evidenced by the strong inflows at the start of the year. Therefore, we are bullish on the asset class this year.

Looking at EM corporate bonds, excluding the idiosyncratic cases of Russia, Ukraine and China, the rest of the universe is running at a default rate of roughly 1.2% (on a rolling 12m basis, source JPMorgan). Net leverage looks pretty low at 1.2x (source JPM, as of end of 2021), which is close to the lowest in history, providing a strong fundamental backdrop. Liquidity is also in a good position with interest coverage ratio running at 10.5x (source JPM, as of end of 2021). Many high yield (HY) sovereign issuers today see their debt trading at prices well below a potential recovery rate in case of default, while still being solvent.

On a regional level, we are currently finding the best opportunities in Latin America and Africa, while we recently brought our positioning in the Middle East to more neutral territory after being overweight the region for most of 2022.
Latin American growth
Our call on Latin America has worked well. Growth has surprised to the upside, and the region’s central banks have been fighting to keep their reputations intact. Mexico and Brazil started to hike rates well before developed market (DM) central banks. Positive real rates are something that only a few Latin American countries have today. So, central banks are near the end of their tightening cycle, inflation is peaking, and trade balances look strong in many countries. For us, these are promising signs for 2023. The major concern of late in Latin America has been politics, but where we have had less market-friendly governments coming into power, damage in terms of fiscal expansion has so far been pretty limited. In 2023, the political overhang looks much smaller given the relatively lighter election agenda. However, recent events in Peru and Brazil show that caution is always needed.

We also think HY countries in Africa provide interesting opportunities, especially if the environment becomes more positive for EM. However, in our view, avoiding more complex situations (e.g. Ghana) is crucial.
Middle East fundamentals
In the Middle East, oil prices have benefited countries such as Saudi Arabia, UAE and Oman, where we have seen significant improvement in fiscal balances. Kuwait alone has seen its budget deficit improve by roughly 19% during the year. Oil companies are producing enormous cash flows, and the World Cup has also brought investment momentum. We think fundamentals already reflect this, and valuations now are largely priced in to these improvements. While we brought our overall allocation to neutral, we think there are some still some interesting areas for investors. Sectors such as real estate and financials, or perhaps HY energy exporters, might benefit via second order effects and are offering interesting spreads.

Looking at the overall emerging market debt asset class, we still believe corporate bonds are the most attractive. The yield to maturity available is still quite high, while duration for the asset class remains contained. We think that short duration EM corporate bonds compensate well those investors willing to wait for future developments to play out. Of course, there are also risks. The outlook for global growth demands caution as spreads could clearly go wider in a recessionary environment; however, the entry points look attractive to us, especially for those investors with a longer time horizon. Refinancing risk for weaker issuers and geopolitics (especially in Taiwan) are two additional aspects we continue to monitor very closely. As active investors, we are able to quickly transform our positioning, including the option to hedge some of these risks as they arise.

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