THE world is undergoing rapid transformation as the tussle between the US and its rivals – mainly China – heats up.
While the two largest economies dominate headlines, the smaller emerging market countries offer some of the most interesting opportunities for debt investors in this “new normal”.
Investors looking to diversify across the emerging markets will find a more complex landscape than the contradictory world of the Cold War, or the Western-led global order that emerged afterwards.
But they should not fear the complexity. Last year, the JP Morgan EMBI Global Diversified Index was up 11 per cent.
Broadly, emerging markets are positioned to play a pivotal role on the world stage as global dynamics motivate leading powers to make attempts – primarily economic and financial – to attract such economies and “geopolitical swing states” into their respective spheres of influence. They do this through positive inducements, such as concessionary lending, infrastructure finance, supply-chain partnerships and technological alliances.
Investors, however, should not view the emerging markets as a uniform group. They span the spectrum in geography, development and degrees of resilience. This creates a diversified opportunity set for portfolios. A judicious combination of emerging market exposures could drive attractive performance.
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So, where can investors find value in emerging markets this year?
Sovereigns offer attractive yields
The best opportunity appears to lie with the emerging market hard-currency sovereigns – government bonds issued by emerging countries in stable currencies such as US dollars.
As emerging markets continue to normalise from their multi-year shocks, their economies remain resilient, with manageable financing needs.
Based on current yields, the returns of emerging market hard-currency sovereigns are already attractive. Even a mild spread-tightening could raise their total returns to double digits, while core developed market sovereign bond yields are declining.
Spread-tightening refers to a decline in the yield differential between two bonds of the same maturity but different credit quality. Against the backdrop of declining inflation, mild economic growth and the Federal Reserve’s monetary policy easing, the spreads between higher-quality developed market investment-grade debt and riskier high-yield emerging market bonds will likely tighten.
Regionally, there are opportunities in Central Europe, Latin America and Asia. Even countries in default – including Zambia, Ghana and Sri Lanka – are incentivised to restructure. This can help make the debt dynamics sustainable, and, over time, bring in fresh capital to help the economies grow. Post-restructuring returns can be positive for investors as well.
Other structural changes that positively impact segments of emerging markets include reducing supply chain reliance on China, and the prospect of increased foreign direct investment across other emerging markets. There is value in emerging market corporate “BB”-rated and “BBB”-rated bonds in countries such as India and Mexico, which are growing strongly and benefiting from the shift away from China.
Friendshoring – a growing practice where supply chain networks are focused on political and economic allies – could also benefit countries already well-connected to existing trade chains and will likely continue to attract investments from existing partners.
Disinflationary trends unlock value in foreign exchange
Within local rates, long rates in Latin America are attractive, while they are mixed in Asia. Disinflationary trends remain in many emerging markets, and real rates are positive.
Specifically, Brazil, Mexico and South Korea stand out, as Brazil is expected to cut rates to below 9 per cent and Mexico should start cutting rates in the first half of 2024. Caution is advised for South Africa, Hungary and Chile.
In emerging market foreign exchange (EMFX), one should not expect persistently strong US dollar performance, given expectations of Fed rate cuts. Alpha opportunities exist in relative EMFX positions. Many of the most preferable emerging market currencies tend to feature a high carry, or are benefiting from relatively higher growth and flows.
In Latin America, the Brazilian real and Mexican peso look attractive. In Asia, relative value positions favour the Indian rupee and Philippine peso versus the New Taiwan dollar.
Investors should remain mindful of tail risks from global growth uncertainty and geopolitics – especially for countries seeing elections this year, such as Mexico, India and South Africa. Of course, the US may also introduce uncertainty.
A barbell approach – investing in a mix of resilient investment-grade and higher-quality “BB” sovereigns, quasi-sovereign and corporate bonds in the seven to 10-year segments of the yield curve, along with very short-maturity single “B” and lower-rated sovereigns – could drive better outcomes.
With the macro story of high inflation and escalating interest rates fading into the rear view, this will be a year when an active investment strategy based on fundamental analysis and valuations of debt securities is critical.
Last year’s returns in emerging markets debt more than held their own. The set-up for this year should attract investors back to the sector.
The writer is head of emerging markets debt at PGIM Fixed Income
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