This time last year commentators were queueing up to tell us that 2021 was going to be a bumper year for emerging market debt (EMD). It didn’t quite turn out that way. EMD has modestly underperformed developed markets and sentiment has turned increasingly negative as we approach year end. Looking ahead to 2022, the market narrative is pessimistic. Investors are worried about China, Covid, inflation, higher US treasury yields, and a rising dollar. However, there are reasons to think that the outlook for 2022 isn’t quite so bad: if investors were so wrong about this year, could they be getting 2022 wrong as well?

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 

Pretty resilient

To put this in perspective, this is a year where emerging markets have not had the extraordinary stimulus we have seen in developed markets, and where they have had to contend with high food and energy inflation. In addition, we have seen a number of crises: in particular ongoing volatility in China real estate, where 40% of bonds are trading under 50 cents2. We’ve also seen volatility from Turkish politics, fears of war in eastern Europe, Marxists coming to power in Peru, and others. In that light, EMD has held up pretty well.

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. 
Emerging markets offer higher yields

Excessively bearish

The other difference has been the relatively slower pace of vaccination in EM, but we expect a catch up in 2022. Chinese real estate volatility has also been a big drag on EM performance. We see this as a self-inflicted problem: China is trying to deleverage its property sector, but has plenty of tools at its disposal to reduce pressure and is highly likely to do so ahead of the party congress next year.

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.

Yield attractive

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.

1 Source: Bloomberg, 1 January to 23 November 2021
2 Source: Bloomberg, as at 9 November 2021
3 A measure of bond price’s sensitivity to changes in interest rates

The value of active minds: independent thinking

 

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