Tailwinds for Emerging Markets debt

Following double-digit gains in US dollar terms in 2023, the Emerging Markets Debt Hard Currency (EMDHC) asset class has continued to make progress in 2024. Year-to-date, further spread tightening – particularly in Africa and the CCC-rated segment – has outweighed the negative impact of the upward shift in the underlying US Treasury yield that coincided with significantly scaled-back expectations about the extent and magnitude of US Federal Reserve (Fed) interest rate cuts in 2024.¹

Risk assets have enjoyed a supportive underpinning from data showing economic resilience in the US and optimism that the “soft landing” narrative is holding. Within the EMDHC space, “risk-on” appetite has coincided with the reopening in primary market access to a number of high yield frontier markets like Ivory Coast, Benin and Kenya. We have also seen very strong demand for debt issuance by investment grade (IG) countries like Saudia Arabia, Mexico, Hungary, Slovenia, Indonesia and Poland.²

As discussed further on in this article, we continue to see several tailwinds for the EMDHC asset class. Overall, we are more optimistic about the outlook for EMDHC relative to developed market (DM) credit, although EM country differentiation (return dispersion), in our view, will remain a key theme for active investors in this market.

Valuations

EMDHC sovereign credit spreads are currently tight, sitting at the low end of historic ranges, particularly once adjusted for the distressed (CCC and lower) segment.³ This means that in terms of aggregate credit beta risk exposure (duration-times-spread), we don’t think it makes sense for investors to be positioned aggressively relative to the benchmark JP Morgan EMBI Global Diversified Index at this juncture.

That said, current EMDHC spreads should be viewed in the context of developed market credit spreads, where valuations are also tight – if not tighter. EMDHC valuations still look attractive relative to comparable US corporate debt, for example.

EMDHC spreads, in our view, are unlikely to widen materially in the near term.⁴ Reasons are as follows:

• Our forward-looking credit rating model indicates that overall credit quality for countries in our universe – following severe hits to their public finances during the COVID years – is likely to improve in 2024 and 2025;
• Attractive (high single-digit) yields in our investment universe offer a buffer against potential spread widening, as well as providing a potential boost to total return prospects (See Figure 1); and
• As markets becomes more focused on growth and somewhat less on inflation, we expect a re-emergence in the negative correlation between EMDHC spreads and US Treasury yields, which could provide some protection if US economic growth disappoints, as wider spreads would be mitigated by lower underlying US Treasury yields.

We continue to see relative value opportunities in our universe, notably among BB/B names in the high yield segment. Recently, there has been some compression in single-B spreads, so, looking ahead, we expect further excess return upside from here on to be more country specific.

In essence, we think investors can continue to achieve attractive total returns from this asset class even considering where spreads are currently. Figure 1 shows our estimated total returns for 2024 based on potential rates/spread moves. It shows that, for the asset class to deliver a negative total return in 2024, we would need to see a substantial rise in both EMDHC spreads and the US 10-year Treasury yield.

Supportive tailwinds

The global market environment looks to be mostly supportive for the asset class. The following factors, in aggregate, represent tailwinds for EMDHC in our view:

• While we have seen rate volatility recently and indications that the downtrend in US inflation has been stalling (much less so elsewhere), the consensus view continues to hold that the Fed is now most likely at terminal rates, with the bar for rate hikes being high.⁵ This means that US Treasury yields are unlikely to be a significant headwind for EMDHC. Further, if history is a guide, EMDHC returns in the two years following the end of an interest rate tightening cycle have been above average.
• The chances of a soft-landing in the US have increased, and central banks have ample ammunition to ease policy/cut rates if required. Further, unless we continue to see positive growth surprises in the US relative to the rest of the world, we may see a weaker bias to the US dollar, which translates positively in terms of debt sustainability for sovereign issuers of US-dollar debt.
• Leading indicators in emerging markets have recently improved, suggesting that a recovery is taking shape.
• Emerging markets are ahead of the US in the cycle. Many EM countries have ample scope for monetary policy easing due to their higher starting point for real rates and improving inflation dynamics. So far in 2024, we have seen further central bank easing in the EM space.
• China’s economic growth has been slowing, but we expect a “muddle through” scenario, not a crisis. The announcement of the “around 5%” growth target looks ambitious (versus consensus forecasts of around 4.5% for 2024) and may hint at further targeted stimulus. The property market slump has hurt confidence and the unwillingness of households to spend savings remain headwinds in China. Nevertheless, there are early signs of stabilisation as recent Purchasing Managers Index (PMI) readings have come in stronger than market consensus and investment banks are revising 2024 growth projections upwards.⁶ The negative spill-over effects from slowing growth in China on EM will be likely more muted than in the past but could weigh more heavily on specific commodity exporters.
• Economic growth in emerging markets (EM) is continuing to outpace growth in developed economies, including the US. Our base case is that the emerging market/developed market economic growth differential is shifting higher over the forecast horizon, although so far in 2024, better US growth has delayed a widening in this differential. Figure 2 shows growth forecasts for EM countries versus the US, based on the International Monetary Fund’s (IMF) most recent outlook.

Fundamentals set to improve

Based on our forward-looking credit ratings model, we expect overall credit quality for the Emerging Market Bond Index (EMBI) universe to improve in 2024 and 2025. Drivers for this are mainly economic recovery and some fiscal consolidation.⁷ A notable positive so far this year has been the ability of some high yield countries – including those in sub-Saharan Africa – to issue new debt.

Meanwhile, progress is being made in restructuring cases and we see no further sovereign defaults in 2024. The most vulnerable countries in our universe are currently in funded IMF programmes and accessing other sources of financing. In our view, the risk of broader contagion from the group of distressed countries to the overall emerging markets asset class is limited.

Market technicals – a bright spot for 2024?

Prior outflows in 2022 and 2023 have left a cleaner starting point for the asset class in terms of market technicals. In our view, demand/supply dynamics could potentially turn more supportive for the asset class later in 2024.

Higher all-in yields in fixed income could support demand from EM investors and bring sequential improvement in flows, although this is largely contingent on Fed rate cuts coming through. In particular, if the US dollar cycle turns down, we might expect to see increasing allocations into EM assets given the negative correlation between the US dollar and EM capital flows.

Elevated dispersion creates opportunities

In previous client communications, we have highlighted the high level of dispersion – as measured by standard deviation of credit spreads – within our investment universe. This continues to be the case and we expect dispersion – and the gap between winners and losers – to remain elevated as we move through the cycle. For active investors, this equates to an opportunity to add value relative to the JP Morgan EMBI Global Diversified Index (EMBIGD). With careful issuer/issue selection – and without the need to take outsized “bets” – we believe it is possible to continue to deliver incremental positive excess returns while also harvesting the attractive carry currently on offer within our universe.

Important information

Past performance does not predict future returns. There is no guarantee that past trends will continue, or forecasts will be realised.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.

Beta measures the volatility of a security or portfolio relative to an index. Less than one means lower volatility than the index; more than one means greater volatility.