While 2021 wasn’t the record-breaking year some pundits expected, EMD actually held up pretty well. Investment grade corporate debt is down around 0.40% at the time of writing, significantly outperforming similarly rated debt in the US. Emerging market high yield debt, which are considered riskier than high-grade bonds, has underperformed US high yield, but has returned over 2%.1
2021 has also been a year of significantly higher US dollar and interest rates. Orthodoxy would tell you that EMD is vulnerable to these factors, but it’s been pretty resilient. Emerging Market (EM) countries (with some notable exceptions) are much more prudent these days, and they are also much less reliant on external funding from developed market, with many more local investors who tend to invest for longer.
One of the reasons EMD has lagged developed markets is EM countries have had to tighten monetary policy faster. Being more sensitive to the food and energy inflation that has dominated this year, almost all EM central banks taking measures to cool price pressures. We expect that a lot of this inflation is transitory and should slow in 2022, especially given we have already seen a significant move in the US dollar. This will allow EM policymakers room for manoeuvre and allow interest rates to stabilise.
Market sentiment towards EM has also become excessively bearish. EM is already one of the most underowned parts of fixed income, particularly corporate credit, and in recent months investors have further reduced allocations. Long experience tells us that particularly in emerging markets, investing at periods of weakest sentiments can be rewarding. In addition, on a ratings-adjusted basis, EM high yield, which are rated lower than the bonds considered to be in the safest category, is the cheapest it’s been for five years relative to developed high yield.
We expect that the potential onset of inflation will create more opportunities for us, and reward investment process grounded in fundamental research. For now, in our strategies duration3 is low, which means that if interest rates rise it may beneficial, and have virtually no EM FX risk, and have virtually no EM currency risk. We are protecting portfolios from higher inflation by investing in companies with US dollar exposure, and the ability to pass inflation on to consumers. We still find plenty of great investment opportunities, such as Latin American companies with exposure to the strong US consumer, renewables, and logistics issuers in India, and are even finding interesting opportunities at distressed valuations in Turkey and China.
In a world where 90% of fixed income yields less than 3%, the higher yields and the spread premium offered by investing in EM is hard to ignore on a yield basis alone: and 2022 may afford a better investment opportunity than many think.
Under the bonnet of EMD there are some surprises in performance. Turkey and Argentina, despite the alarmist headlines, are up on the year. On the other hand, China which typically is the powerhouse of stimulus in EM, is down for the year. This points to the value of differentiation within EMD which we always believed as the key method for generating alpha rather than painting the whole of EMD with one brush.
2 Source: Bloomberg, as at 9 November 2021
3 A measure of bond price’s sensitivity to changes in interest rates
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