Investors in Australia and globally are increasingly turning to EMD for higher yields compared to developed markets and to diversify portfolios amid global uncertainties. The dynamism of emerging economies, alongside unique risk-return dynamics, attracts investors seeking income generation and resilience. Despite volatility, strategic inclusion of EMD allows Australian investors to tap into developing nations’ growth potential, offering specialised diversification and long-term returns.
Entering 2024, the global fixed income markets, particularly EMD, reflect a similar outlook to the previous year. Optimism for enhanced duration performance is tempered by macroeconomic influences from both the United States and China. The aftermath of an unprecedented rise in global risk-free rates, a resilient US dollar, and stringent global financial conditions persists. Despite these challenges, emerging countries have outperformed expectations, demonstrating remarkable resilience in economic growth and fiscal balances. This resilience is noteworthy amid a weakened China and the ongoing tight monetary policies of the Federal Reserve and the European Central Bank, which sustained the strength of the US dollar until recently. This resilience can be attributed to a mix of favourable factors for emerging markets, including the timely enhancement of risk premia by EM (emerging market) central banks through proactive rate hikes amid rising inflation in 2021. Additionally, there is a noteworthy stability in commodity prices despite the ongoing Chinese economic deceleration.
As global fixed income comes back in favour, the persistence of a number of risk-adjusted value opportunities across the three EMD asset classes, including in frontier countries and the fundamental resilience exhibited by most countries and issuers, should mean that any small positive reallocation by global investors could have a magnifying effect in bringing local yields and credit spreads way beyond fair value at times.
EMD valuations remain attractive, adjusted for the real (if not perceived) level of macro or credit risks. EM corporate credit no longer looks like an asset class of its own, but rather represents a diversified field for resilient income opportunities, sectoral thematic baskets to complement a country macro view, or certain special credit situations. Principal Finisterre continues to appreciate the resilience offered by EM corporate fundamentals which often create a natural arbitrage versus DM (developed market) credit, in that similarly rated EM corporates tend to exhibit much better credit metrics and access to financing via their domestic banks than their US or EU peers.
We also note that EM corporates have generally tended to be proactive in refinancing early, extend maturities and smooth their debt profile during the COVID-19 period, where they also took advantage of generous liquidity provisions by their own governments. Considering the difference of DM HY markets, the EM corporate space also exhibits very few over-leveraged private equity transactions with high short-term refinancing risks.
When it comes to sovereign external debt, the overall JP Morgan EMBI Global Diversified Index spread remains near the high end of its 250–450 bp long-term range over Treasuries. A lot has been said about how this apparent index spread attractiveness hides a significant bifurcation between tight BBB/BB names and risky B/CCC names. We do sympathise with the idea that true value lies more on the side of the stressed and distressed space, which warrants an uncompromising approach to fundamental analysis, and sometimes implies taking a view on specific event-driven situations. Yet, as long as one can develop a strong fundamental conviction, this space represents an attractive source of Alpha to an EMD portfolio.
Last but not least, local currency debt still trades near its most attractive historical and cyclical levels (especially on an ex-China/Southeast Asia basis). Across EMs, disinflation is now well entrenched, thanks to EM central banks having done a fine job of acting early and forcefully to preserve their inflation targeting credibility. This leaves the space exhibiting some of the highest levels of real and nominal yields of the past 20 years.
We believe that our scenario of “continuing 2024 disinflation with a pronounced US growth slowdown, yet not morphing into a harsh recession” is consistent with either moderate USD weakness or broad stability. We would likely remain in the middle part of the so called “USD smile”, i.e. away from the two extreme environments of USD strength, namely exceptional US strength or harsh recession infecting other parts of the world. Such an environment would allow, more than in 2023, non-US regional or domestic factors to play a more dominant role in most currencies’ behaviour and allow the EM foreign exchange (FX) carry trade to express itself again.
Despite our assessment that, as of the end of 2023, most EM risks were properly priced and identified, EMD continued to see unrelenting outflows from global investors in both local and hard currency debt in 2023, which brings the cumulated outflows since the start of 2022 to about six times the amount we had during 2013, the year of the “taper tantrum”. We have reached the point where, in barely two years, 50 per cent of all global inflows into EMD since 2004 have now left the asset class. We see this level of negativity vastly unjustified vis-à-vis the true situation of EM fundamentals, which remained extremely resilient besides the usual frontier market suspects embroiled in restructuring or those flirting with a credit event but still paying their coupons (although we note that frontier credits did perform finely as a group in 2023).
The combination of fair fundamentals, well identified risks, ultra-low ownership by still doubtful global investors, and attractive valuations, makes EMD the most asymmetric asset class to embrace better days for global fixed income, which will be highly likely to perform healthily in 2024. The outlook for EMD has continued to improve in recent years and it is expected to see stronger returns in 2024 as macroeconomic conditions fuel global growth, but hopefully with a little less volatility along the way.
Damien Buchet, chief investment officer, Principal Finisterre (Principal Asset Management)
