By Dr Ricardo Adrogue, head of global sovereign debt and currencies at Barings
The upbeat note on which emerging market debt entered the year continues to prevail. But while tailwinds exist, there are a myriad of potential risks to navigate in the coming months.
Improving prospects for global economic growth, coupled with the Federal Reserve likely being at or near peak rates, have buoyed sentiment across EM debt.
Spreads continue to grind tighter across sovereigns and corporates and while the aforementioned factors are certainly reasons for optimism, the significant tightening in spreads is also evident among weaker EM regions and credits.
This widespread rally, when viewed in the context of what appears to be a challenging last mile in the global battle against inflation, ongoing wars in Europe and the Middle East, and elevated political uncertainty around the world, begs the question – are markets getting ahead of themselves?
A supportive backdrop, but persistent risks
With the US economy growing, China’s weakness appearing to have found a bottom, and the rest of Asia continuing to gain strength, sovereign hard currency debt remains on solid fundamental footing as recession concerns ebb.
In particular, the strength of the US economy benefits countries in South and Central America and the Caribbean given the multiple linkages between them from trade to tourism.
The technical picture also remains supportive for EM debt, with institutional investment flows in EM turning positive in 2023 following a year of outflows. Outflows were dominated by retail funds last year, but developed market commercial banks increased their exposure to the asset class. Historically, smart money inflows have been a leading indicator of overall investor inflows into EM debt.
However, the overall picture is also one of a number of potentially significant risks. There is the possibility for further escalation in the Russia-Ukraine war – which could have a contagion effect on neighbouring countries – as well as elevated political risk given the number of elections around the world this year.
On the positive side, many EM election outcomes are priced into the market and therefore unlikely to result in any major disruptions. Perhaps counterintuitively, the US presidential election may be the one most likely to introduce volatility to the EM market – if Donald Trump returns to office, a number of major international policies could be called into question.
In this environment, we see value in investment grade (IG) sovereigns with solid fundamentals, particularly in BBB countries such as Mexico, Uruguay, Bahamas, and Indonesia.
Select opportunities also remain in the high yield space, especially where spreads continue to offer a healthy overcompensation for default risk. Specifically, we see value in high-quality BB sovereigns such as Dominican Republic, Costa Rica, Jamaica, Paraguay, and parts of Eastern European.
In the local debt space, we are less constructive on local interest rates because we expect to see fewer and smaller cuts from EM central banks going forward. However, there are a few EM countries that still have room to cut, such as Mexico and some Central and Eastern European nations.
The growing opportunities in IG and select HY
Spreads in the EM corporate market continue to tighten in tandem with other markets and are approaching post-crisis tights. However, absolute yield levels look attractive relative to many other fixed income asset classes.
While there are potential significant risks on the horizon that could derail this tightening and drive spreads wider — which provides a reason to advocate for some degree of defensiveness — we also see tailwinds supporting the market.
In particular, funds are being reallocated from money market funds into developed market investment grade (IG) asset classes, which is providing crossover demand tailwinds for select segments of EM corporates.
Specifically, we see EM IG corporates (which constitute roughly 60% of the EM corporate debt universe) as the segment that is not only benefitting from demand tailwinds, but is also likely to benefit from potentially attractive convexity when the Fed starts to cut rates.
We also see value in select idiosyncratic opportunities in the high yield space, as the segment is likely to benefit if economic data continues to point toward a ‘no landing’ scenario and sentiment improves for riskier debt. In addition, corporate fundamentals overall remain sound for both IG and HY companies.
From a sector perspective, we remain cautious around sectors which have been impacted by the lower cost product exports from China such as petrochemicals and steel.
We also see some technology, media, and telecommunications companies challenged with the aftermath of higher funding costs, the capital expenditure overhang from previous years, and a reduced ability to pass through costs to consumers.
A cloudy crystal ball
While current conditions remain favorable for EM debt overall, the potential for disruption exists across many fronts – and either political or geopolitical events could pose risks for EM assets going forward.
Despite the riskier backdrop, we believe the diversity within EM sovereign, corporate and local debt provides a breadth of opportunities across issuers and regions which have unique performance drivers.
In our view, rigorous, bottom-up credit and country selection, combined with active and discriminating management, remain paramount to managing the risks across the market, as well as to identifying the issuers that are well-positioned to navigate the uncertain environment.
