Emerging Markets Debt: a bright spot despite an uncertain macro picture

Emerging market debt hard currency (EMDHC) assets proved resilient in 2023 in the face of tighter financial conditions, slowing global growth, and investor outflows. As represented by the JP Morgan Emerging Market Bond Index Global Diversified (EMBIGD), total returns for 2023 (year-to-date, as at 31 October 2023) stood at 0.39% in US dollar terms, dragged down by the rise in Treasury yields. Sovereign credit spreads have been very resilient – moving tighter year to date – resulting in positive excess returns over this period.¹

For 2024, we see a number of positives for the asset class (discussed later on), not least attractive carry opportunities and potential tailwinds from the end of US Federal Reserve (Fed) tightening. That said, broader market sentiment is always an important driver of the direction of EMDHC assets and with this in mind, we believe ongoing global macro uncertainty may temper upside potential.

Indicative of the wide range of possible outcomes for the US economy, Goldman Sachs has year-on-year real gross domestic product (GDP) growth for 2024 at 2.1%, the International Monetary Fund (IMF) has year-on-year real GDP growth at 1.5%, while consensus forecasts for the US next year are for 1% growth.² While developed economies have been more resilient than expected, leading indicators are not signalling an imminent upturn, and recession risks remain elevated in the US and Europe. That said, the major central banks now have ample ammunition to ease policy/cut rates. The end of Fed tightening cycles has typically been a more positive environment for EMDHC, particularly if the US dollar weakens alongside.

JHI

Improving EM-DM growth differentials. The recovery in growth alpha (i.e., the difference between Emerging Market and Developed Market (DM) economic growth) seen in 2023 is forecast to be sustained in 2024, making emerging and developing countries more attractive for global flows of capital. Figure 1 shows the widening disparity in year-on-year real GDP growth forecasts for emerging economies compared to those for advanced economies.

Credit fundamentals are holding up. Developing countries have been making progress on recovering from the economic shocks of the past three years, despite social constraints. In our view, the impact of positive policy adjustments is often underestimated over the medium term and fundamentals currently are not as bad as some headlines suggest. Clearly, debt accumulation in China is still rising, but if you look at debt weighted by the widely used EMBIGD benchmark (China’s weighting is only around 4.7%), fundamentals at the aggregate EMBIGD level are holding up. See Figures 2 and 3.

Attractive yields and prospective returns. As can be seen in Figure 4, yields on the EMBIGD have risen significantly above their 20-year median level. Yields at this level are supportive for total returns and offer a meaningful buffer against potential spread widening.

Putting this into perspective, the matrix in Figure 5 shows estimated prospective percentage returns over a one-year horizon, based on various EMBIGD spread levels and US 10-year Treasury yield levels. It shows that, based on spreads/yields as at 31 October 2023, investors could expect an annual return of 7.6% assuming the EMBIGD sovereign spread and US 10-year Treasury remain constant over the period. For the index to deliver a negative return (top-right), we would need to see both a significant widening in EMBIGD spreads and a substantial rise in Treasury yields. If you believe, as we do, that US Federal Reserve is now at terminal rates, then US Treasury yields could actually be a supportive tailwind for the asset class in 2024.

High yield segment offers more interesting opportunities

Overall, sovereign credit spreads are pricing in more of a soft landing – particularly, once headline EMBI spreads are adjusted for the distressed (CCC and lower) segment. Our universe continues to see elevated spread dispersion and desynchronisation across countries, creating opportunities for active investors. Given the bifurcation in spreads (Investment Grade versus High Yield), we see an opportunity to capture attractive carry by favouring the shorter end of the curve and paying more attention to BB and single-B rated countries, where valuations are more compelling.

Market technicals

Market technicals could well be better than many expect. Perhaps too much focus is put on the record outflows seen over the last two years. The flip side is this has left a cleaner starting point in terms of investor positioning, and higher all-in yields in fixed income should support demand from EM dedicated investors. A more bullish decline in yields next year may see market access returning for some high yield countries, which creates a positive feedback loop.

China growth slowing but will muddle through

Much has been written about China’s structural slowdown. More recently, we have seen better-than-expected Q3 GDP growth (4.9% year-on-year, albeit following a weak Q2 figure) and a modest policy stimulus package. For us, the stimulus is too small to revive “animal spirits” and does not represent a baseline change, but it does serve to signal that the government is more focused on the economy than the market may have previously thought, and it does reduce downside risk over the next 3-6 months. The property market slump has hurt confidence, while elevated youth unemployment and an unwillingness of households to spend savings remain consistent headwinds. We expect a muddle-through scenario, not a crisis.

IMPORTANT INFORMATION

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.

 The 10-Year Treasury Yield is the interest rate on U.S. Treasury bonds that will mature 10 years from the date of purchase.

 Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.

Credit Spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers and narrowing indicate improving.

Emerging Markets Debt Hard Currency Composite, benchmarked to the JP Morgan Emerging Markets Bond Index Global Diversified includes portfolios that seek to provide a total return in excess of the benchmark. Portfolios will typically invest at least 70% of its net assets in emerging market bonds and other fixed and floating rate securities denominated in hard currency. The portfolios may invest up to 10% in distressed debt securities, i.e., securities that are rated at CCC-/Caa3 or below, and up to 10% in non-rated debt. Portfolios may utilize derivative instruments for investment and hedging purposes. The composite was created in September 2022.