Emerging Market Debt – Looking at yields, and the biggest driver – inflation and policy rates – gives us grounds for optimism
After a dire year amid rising interest rates in 2022, emerging market (EM) bonds in both local and hard currency did well in 2023. At the time of writing, both asset classes had outperformed US developed market (DM) government bonds, US Treasuries (which admittedly had a poor year) and investment-grade corporate credit; local currency debt also outperformed US high yield, despite an indifferent year for the dollar.
Grounds for optimism
Across the two calendar years of global rate hikes, EM has performed solidly. A rally late in 2022 (when DM rates continued to rise) meant that EM rates rose less than DM rates over the course of 2022. Outperformance was even more notable in 2023 – by November, EM rates were over 1% lower than their peak a year earlier. DM yields did not peak until October 2023 and are only 25 bps off this peak as we write.
Looking at yields, and the biggest driver – inflation and policy rates – gives us grounds for optimism. Most of our optimistic views for 2023 were vindicated – lower food and energy prices had a bigger impact in EM, where commodities play a larger role in consumption and services play a smaller part in economic activity. Inflation fell quickly and central banks responded – generally more cautiously than their DM counterparts but through 2023, even hawkish institutions like the central banks of Chile and Brazil had embarked on cutting cycles. Looking across the EM world we continue to see plenty of value. Several EM countries are showing forward-looking real yields much higher than longer-term averages, even allowing for further disinflation. We find Mexico especially attractive here.
This rosy rate picture leaves us with two concerns: first, while EM currencies have done enough to leave EM returns very comfortable compared with non-US DM, dollar returns have been at the mercy of dollar strength; second, bond markets in DM are clearly straining at the prospect of unprecedented net supply, as quantitative tightening coincides with the prospect of dramatically looser fiscal policy globally.
The issue for local currency EM continues to be the extent to which global growth is US centric. In this environment, the dollar is almost inevitably strong, especially now that the US is once again not a significant oil importer (due to fracking). Since the Global Financial Crisis (GFC), the dollar has risen in 10 out of 14 years, and the pre-crisis outperformance of local currency EM debt vs USD EM debt has reversed.
One positive: we see scope for stronger Chinese growth – which traditionally lifts especially the currencies of commodity exporters, but it is harder to be sanguine about Europe. Tight fiscal policy and institutional rigidities continue to weigh on growth in the region. There is also the ongoing threat of the cut-off of Russian gas sales. While last winter demonstrated that Europe can cope as long as the winter is mild, the large increase of gas usage if winter is less benign leaves the continent at risk.
Rising global government debt
The rising global government debt story should, on the face of it, be a positive for EM. Government debt – net or gross – in EM is generally much lower than in DM and has risen less since the GFC (including during the Covid pandemic). We are uncomfortable with this glib narrative for a number of reasons: a rising term premium seems unlikely to restrict itself to DM; real yields remain higher in EM and institutions weaker, so financeable levels of government debt will be lower; and the countries with the lowest debt are inevitably not the large issuers where market exposure is. We see scope for some outperformance but see material risks to a fundamentally benign outlook for EM rates.
The story for hard currency bonds – sovereign debt from EMs issued in DM currencies – was, as usual, very similar to that for corporate credits of similar ratings issued in the same currencies. As befits a strong year for risk assets, the lowest-rated credits performed best in 2023, with distressed countries like Ukraine, Sri Lanka, Pakistan and Venezuela returning over 40% (159% in the last case). Here the outlook for 2024 is simpler – absent a recession, or a slowdown sufficient to have recession-like impact, the very high yields should produce strong returns, with the weakest part of the credit stack performing best, although unlikely to be quite as outstanding as in 2023.
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