Markets have shown many times that the best time to buy is just when the bad news can’t get any worse. “Buy when there’s blood in the streets” as the old saying goes. It might sound a bit extreme to modern ears – more appropriate perhaps for the Napoleonic Wars, when it was supposed to have been uttered.
The parade of bad news about emerging markets (EM) has been suffocating. Russia and Ukraine; China real estate, gaming and tech; China and Taiwan; LatAm elections; Turkey; African coups. Food and energy price inflation has been tougher for emerging markets, which are tightening policy as a result (we’ve seen a total of 3770 basis points of rate hikes in nine months). Volatility in US interest rates and dollar strength are traditional headwinds. Is our long-running theme of EM resilience being tested? We think these problems are now priced in – EM hasn’t been this cheap relative to developed markets for five years at least – and we may be close to the sort of buying opportunity that only comes around every few years.
We spend a lot of our time stepping back from the noise and relying on our own fundamental analysis of companies and countries across the globe. There’s a disconnect in our view between some of the bad macro noise and the fundamental health of the issuers we look at. Here’s some of the bottom-up views from our team of regional analysts.
“CEOs and CFOs are doing their best as the property development sector will see substantial consolidation and survivors will win.” says Xuchen Zhang, who has just returned from a six-week field trip where he visited companies in China. “The liquidity problems at many developers have been caused by policy tightening, and if companies can hang on long enough for the policy climate to improve, the vast majority of them will be just fine. That’s why we’re seeing efforts such as selling property portfolios and share placements to raise cash to meet short-term obligations. As we get further into 2022, there will be good times to pick up good companies at heavily discounted valuations – if you know how to pick the right ones.” Xuchen is also finding opportunities elsewhere in Asia, in particular in India and Indonesia, where policy is still relatively loose, and companies’ fundamentals are isolated from China real estate.
Alejandro di Bernardo
If Asia was the region that dragged EM debt down in 2021, Latin America held up well thanks to exposure to the US consumer, energy and protein. “Recent volatility has made some of our favourite names start to look much more affordable” says Alejandro di Bernardo. “In particular, strong companies with healthy balance sheets that can weather short term volatility in places like Chile and Costa Rica, where recent political instability doesn’t actually look too threatening, can drive performance in 2022.” His biggest overweight remains Mexico: “I never thought I’d say this, but given Amlo is hamstrung by the political system, Mexico actually looks more stable politically than other countries in the region.”
The biggest worry for global politics right now is that a Russian invasion of Ukraine could spark a wider conflict. “My base case is that Russia uses the situation to win concessions and stops short of war” says Reza Karim. “With Europe preoccupied by Covid and politics, and dependent on Russia for energy in deep midwinter, the opportunity was too good for Putin to ignore. But the consequences of hot war will be hard for Russia, and likely seriously to annoy China as we head towards the winter Olympics in Beijing.” The team have been carefully managing exposure to the region, in particular using credit default swaps to hedge exposure to Russia. That said, “some of my favourite corporates in the region are trading at attractive levels for the first time in years” says Reza, always looking for an opportunity to pick up good names at better levels. The other European reprobate is Turkey, where President Erdoğan continues to insist on looser policy despite high inflation. The team remains underweight.
The Middle East has outperformed, thanks to continued strong performance from energy. Even so, the team have used volatility to add to higher quality names in Bahrain and Oman. “You need to use price action in your favour” says Reza. The team remains overweight Africa, where improving balance sheets and relative stability make selected countries attractive. Reza thinks the recent coup in Burkina Faso won’t cause regional instability.
We have been arguing for many years that investors tend to misunderstand emerging markets: they underestimate its diversity, and they overestimate its vulnerability to interest rates and the dollar. The net leverage of EM credit is 25% lower than two years ago. Reliance on external borrowing has come down drastically – close to 90% of EM government debt is now in local currency, as opposed to 40% two decades ago. Throughout a pretty difficult period of Covid (which hit EM more than DM) and regional instability, the asset class has held up fine in absolute terms, but it’s lagged developed markets.
In our view, much of the bad news is in the price, and in fact there’s a good chance that the news flow improves, and EM debt markets are more sensitive to a positive surprise looking forward. Our base case is that regional tensions dissipate in Europe later this year. China is likely to continue to ease policy as we approach the party congress in the autumn. US interest rates have also moved a long way: markets are now pricing five rate hikes in the next twelve months alone. We think that as inflation pressures ease from Q2 onwards, and growth starts to slow down, pressure on central banks to tighten will reduce.
Another exciting opportunity in EM is ESG as EM catches up with DM standards. Corporates and sovereigns are much more willing to listen and work towards improvement which we as investors can greatly influence. The team has been working heavily on engagement with issuers.
Our team of dedicated credit analysts are still finding lots of issuers to like in EM on a fundamental basis, which is at odds with negative EM sentiment. If as we expect those political and policy macro headwinds ease later in the year, investor sentiment will turn quickly. Relative valuations make EM look very attractive. We see a great opportunity to add risk in EM – if you can pick the winners and avoid the losers.
What lies ahead for EM corporate bonds?
The outlook for fixed income
Hidden opportunities in emerging market debt
Emerging market debt: Winners and losers
Emerging market debt: Is this as bad as it gets?
The value of active minds: independent thinking