Some of the most interesting opportunities for debt investors can be found in smaller emerging markets.
The world is undergoing rapid transformation as the Great Power Competition between the US and its rivals — mainly China — heats up.
While the two largest economies dominate headlines, it’s smaller emerging market countries that have some of the most interesting opportunities for debt investors in this “new normal”.
Investors looking to diversify across emerging markets will find a more complex landscape than the bi-polar contradictory world of the Cold War or the Western-led global order that emerged afterwards.
But they should not fear the complexity: last year, the JP Morgan EMBI Global Diversified Index was up 11 per cent.
Broadly, emerging markets are positioned to play a pivotal role on the world stage as global dynamics motivate leading powers to make attempts — primarily economic and financial — to attract these economies and “geopolitical swing states” into their respective spheres of influence via positive inducements such as concessionary lending, infrastructure finance, supply chain partnerships and technological alliances.
Investors, however, should not view emerging markets as a uniform group. They span the spectrum in geography, development, and degrees of resiliency. This creates a diversified opportunity set for portfolios. A judicious combination of emerging market exposures could drive attractive performance.
So, where can investors find value in emerging markets this year?
Sovereigns offering attractive yields
The best opportunity looks to be within emerging market hard currency sovereigns — government bonds issued by emerging market countries in stable currencies like US dollars.
As emerging markets continue to normalise from their multi-year shock, their economies remain resilient and financing needs will be manageable.
Based on current yields, emerging market hard currency sovereigns returns are already attractive. Even a mild spread tightening could raise their total returns to double digit, while core developed market sovereign bonds yields are declining.
Spread tightening refers to the reducing difference in yields between two bonds of the same maturity but different credit quality. Against the backdrop of declining inflation, mild economic growth and the Federal Reserve’s monetary policy easing, the spreads between higher quality developed market investment grade and riskier high yield emerging market bonds will likely tighten.
Even countries in default — including Zambia, Ghana and Sri Lanka — are incentivised to restructure. This can help make the debt dynamics sustainable, and over time, bring in fresh capital to help the economies grow. Post restructuring returns can be positive for investors as well.
Other structural changes that positively impact segments of emerging markets include reducing supply chain reliance on China, and the prospect of increased foreign direct investment across other emerging markets. There is value in emerging market corporate BB-rated and BBB-rated bonds in countries like India and Mexico that are growing strongly and benefiting from this shift away from China.
Friend-shoring — a growing practice where supply chain networks are focused on political and economic allies — could also benefit countries already well connected to existing trade chains and will likely continue to attract investments from existing partners.
Disinflationary trends unlock value in foreign exchange
Within local rates, long rates in LatAm are attractive, while more mixed in Asia. Disinflationary trends remain in many emerging markets, and real rates are positive. Specifically, Brazil, Mexico and South Korea stand out, as Brazil is expected to cut rates below 9 per cent and Mexico should start cutting rates in the first half of 2024, while caution is advised for South Africa, Hungary and Chile.
In emerging market foreign exchange (EMFX), one should not expect persistently strong US dollar performance given expectations of Fed rate cuts. Alpha opportunities exist in relative EMFX positions. Many of the most preferable emerging markets currencies tend to be high carry or are benefiting from relatively higher growth and flows. In Latin America, the Brazilian real and Mexican peso look attractive. In Asia, relative value positions favour Indian rupee and Philippine peso versus the New Taiwan dollar.
Investors should remain mindful of tail risks from global growth uncertainty and geopolitics — especially for countries seeing elections this year like Mexico, India, South Africa, and of course the US can also introduce uncertainty.
A barbell approach — investing in a mix of resilient investment-grade and higher-quality BB sovereigns, quasi-sovereign and corporate bonds in the seven to 10-year part of the curve, along with very short maturity single B and lower rated sovereigns — could drive better outcomes.
With the macro story of high inflation and escalating interest rates fading into the rear-view, this will be a year where an active investment strategy based on fundamental analysis and valuations of debt securities will be critical.
Last year’s returns in emerging markets debt more than held their own — the setup for this year should attract investors back to the sector.
Cathy Hepworth, head of emerging markets debt, PGIM Fixed Income
