Two of last year’s major headwinds became tailwinds at the start of 2023: China reversed its zero Covid policy and stronger GDP growth expectations returned to China, and we saw a strong rally in US Treasuries. As such, while in 2022 many investors in emerging market debt had followed the usual pattern of “selling first, asking questions later”, as we entered 2023 investors started to return to the asset class, increasing their allocations from underweight to market neutral.

As the year has progressed, however, it now feels like investors are returning to more of a “wait and see” mode, as it feels like the asset class has become a prisoner of what’s happening in the US.
Spreads reflecting worst case scenarios
Despite an initial rally in EM debt at the start of this year, markets have since given back these gains, and EM spreads are now reflecting worst case scenarios. Spreads are around 500 to 550 basis points above Treasuries, which are levels we haven’t really seen since 2008 (with the exception being during the period of global Covid lockdowns). However, fundamentals continue to look strong, with many positive stories coming from across EM.

On the technical side, the amount of outstanding EM bonds has continued to shrink, as issuers have been finding it very expensive to come to market. In 2022, net issuance was -$230bn, and year to date it’s -$66bn. Last year, there were concerns that a lack of access to international markets from issuers could result in a big spike in defaults, but in reality, issuers have been able to successfully tap into local markets instead. This means we’re seeing deeper markets, and there’s not a mismatch between assets and liabilities.

As we move forward, we think uncertainty is likely to continue, with investors remaining in this “wait and see” mode while they wait for the US Federal Reserve’s (Fed) next moves. However, if you look at where spreads are, we take the view that investors are getting paid to wait, and as duration can be easily managed too, right now it’s mostly about avoiding the defaults.
Inflation: less of an issue for EM than DM
Inflation has continued to cause a lot of uncertainty and volatility in EM, as we’ve also seen in DM. Interestingly, however, when comparing inflation in EM against DM historically, it’s the first time since 1999 that inflation is higher in DM than in EM. EM central banks have been more aggressive in terms of tightening, with some of them moving ahead of the Fed. We’re also seeing positive real rates in EM, which is very appealing for international investors who are looking to invest in local markets. Furthermore, if the US dollar weakens, investors get the benefits of FX moves as well.

EM vs DM Consumer Price Index (annual YOY %)

EM vs DM Consumer Price Index (annual YOY %)

Source: Bloomberg, EM CPI vs DM CPI (annual YOY %), 1999 to 2023

Now, inflation expectations in many EM countries seem to have peaked. While we would be surprised if many EM central banks chose to start cutting rates before the Fed does, if EM inflation expectations remain stable or start coming down, EM central banks will have more levers to pull in terms of stimulating their economies. This means EM is not only a growth story, but also an inflation story.

In terms of a possible recession, we don’t know if it’s going to be a deep recession, or a mild one. However, as investors are currently nervous about investing in what they perceive to be “riskier” asset classes, such as emerging market debt, it’s allowed us to go up the credit ladder to access investment grade credits with strong fundamentals at attractive spreads, with these companies being more likely to successfully navigate a recession.
Focusing on differentiation
As always, we emphasise the importance of recognising that every EM country is different, and the investment universe offers huge diversification. As such, differentiation remains key when investing in the asset class.

In terms of recent adjustments, we have increased our Asia exposure, mostly outside of China, with a focus on Thailand, Singapore, Hong Kong and Macau. Given Asia represents 40% of the benchmark (primarily investment grade), the Asia universe tends to be an underweight for many investors. To increase our Asia exposure, we have reduced our Middle East allocation. The Middle East performed well last year given strong oil prices and good liquidity, with locals buying many bonds; however, valuations have started to look expensive, so we have taken some profits, especially in the oil and gas sector. We have been overweight Latin America for some time, and valuations remain attractive there, though we have been shifting our exposure within the region, given the evolving political backdrop.

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