Should investors be more cautious about investing in emerging markets given the current macro backdrop?
Emerging markets (EM) are often incorrectly treated as a “homogeneous” universe – as if all economies in EM are in the same boat and are all affected by similar drivers. However, in reality, our investable universe consists of 70+ countries and offers huge diversification. For example, while some countries in Latin America and the Middle East are heavily reliant in commodity prices, there are others that benefit from weaker commodity prices as they are importers – India, Indonesia and Turkey all benefit from lower oil prices. On the fiscal front, increasing levels of debt is not an EM-specific problem, it’s a global one. As governments seek to support their economies during this crisis, for us, the focus going forward is on what plans they are putting in place to close that gap.

The largest EM economies have learned from the “original sin” of the past, when most of their funding was in US dollars, thereby creating a significant mismatch between assets and liabilities that in some cases pushed countries to restructure or default. Now, with much deeper local markets, they can fund most of their needs in their respective currencies, improving the risk profile. We have already seen countries like Mexico and Brazil bringing reforms back to the table to help lower spending.
Since the initial shock in March, why do you think emerging markets have generally recovered well?

We have seen the same pattern as that from previous crises, where many of the “tourist” investors that entered the asset class just looking for attractive yields, without really understanding underlying fundamentals, ran out the door in light of negative headlines. As a result, the pace of outflows in March actually exceeded those seen during the Global Financial Crisis. Many of these less informed investors view all EM countries as the same. However, for dedicated investors like us, while these knee-jerk reactions may create short-term volatility, they also create great opportunities to pick up attractive bonds at significant discounts. Since 2008, we had not seen such attractive valuations across our asset class as those in March. We have already seen many of these bonds retrace 40-60 points from March’s lows; year to date, both sovereign and corporate hard currency indices 1 are in positive territory after being down in the double digits.

As in developed markets, revisions to GDP numbers across EM will likely continue their uptick as many of the worst-case scenarios priced in during March are being revised and economies are slowly opening up. While a second wave is a risk, we have seen a more targeted approach from governments (e.g. China), which should limit the overall impact to the economy.

Why should investors consider investing in the EM debt asset class in ‘all seasons’? What approach do you think they should take?
It’s becoming very difficult for investors to ignore the asset class, as it continues to be the engine of growth globally. However, it is still heavily underrepresented across many investors’ portfolios, and indices. In a world where 69% of the debt in developed markets yields less than 50bps, EM debt offers an attractive yield premium, as well as the benefits of diversification.

Our preferred approach is through corporate bonds denominated in US dollars, as they offer the best risk-adjusted returns compared to sovereign bonds and local currency bonds. Corporate bonds offer a premium to sovereign bonds, even when they have stronger fundamentals than comparable companies in developed markets, as they are penalised just for being labelled as “EM”. But this discrepancy actually benefits investors in the asset class, as they can access strong fundamentals at cheaper valuations.
Should investors look to invest in EM sovereign bonds or corporate bonds?
Both sovereign and corporate spreads are 100bps+ wider than their pre-Covid levels, and we believe both still look cheap. They have different dynamics and the preference for one over the other depends on investor risk appetite. The EM sovereign bond index has a lower rating and a higher duration than the comparable EM corporate bond index, which means it tends to be more volatile. In other words, if investors prefer to be more defensive, corporate exposure would be best.

Nevertheless, both sovereign and corporate hard currency bonds have provided good risk-adjusted returns historically, and we think this will continue. While leverage has increased for both sovereigns and corporates, it remains moderate, which makes the current spreads look attractive to us.
There is a growing concern about the risk of default by companies, as well as some countries. Are emerging markets the most exposed to this risk?
EM corporates have lower leverage than developed market companies, with the same ratings. This is because EM corporates are deemed to be of higher risk, simply because of where they operate, regardless of credit fundamentals. The default rate of EM high yield corporates year-to-date has actually been half that of US high yield companies. Of the EM companies that have defaulted, their recovery rate (36%) has been double that of US companies (17%). Therefore, EM corporates, especially those that have issued in hard currency, have a lower risk of default than their developed market counterparts. Certain economies such as Lebanon and Zambia are at a high risk of default and are undergoing restructuring discussions, but these kinds of countries account for a very small portion of the EM universe. It is not prudent to tar the whole of emerging markets with the same brush as you miss out on exposure to the wide range of countries that are not at risk of default.
What’s your view on Latin America?

While Latin America continues to be affected by the pandemic, we take a more constructive view on the region, due to three factors. First, we are seeing a ramp up in domestic activity as lockdowns ease and industrial activity starts to pick up. While the pandemic is far from over in countries like Brazil, the reopening of its economy continues, and we are seeing a gradual cyclical recovery from the lows of March and April. The Brazilian government has been quick to implement emergency fiscal measures that will support a gradual recovery in consumer spending during the second half of the year. Meanwhile, in Mexico, industrial activity started to pick up thanks to the re-opening of the economy, with significant improvement in export and consumer confidence indicators. We are encouraged by the recent pension reform proposal agreed between the government and business leaders too. Second, fiscal and monetary stimulus has supported consumer confidence and contained the effect of the lockdowns there. Lastly, we are seeing exports recovering in the region, anchored by Chinese activity.

Successful sovereign debt negotiations in countries like Argentina have also put corporates in a better spot. We believe we can still find resilient corporate stories with stable fundamentals and conservative balance sheets at attractive valuations, though we choose not to hold its sovereign bonds.

We believe valuations in Latin America are attractive relative to other EM regions and developed markets, and we continue to add names with comfortable liquidity, healthy balance sheets and good management.

1 JPM CEMBI Broad Diversified TR Index, in USD, to 30.09.2020