As economies start to re-open and risk appetite increases, emerging market (EM) debt opportunities look attractive, with current prices adequately compensating for risk, according to PGIM Fixed Income.
Cathy Hepworth, managing director and head of PGIM Fixed Income’s EM debt team, says the team’s focus has been to determine which assets will recover first from the economic damage caused by Covid-19-led lockdowns and movement restrictions.
While spreads have recovered some of their losses, as of early June, they are still significantly wider than pre-crisis levels, Hepworth explains. Within that recovery lies a wide divergence between high quality and high yield issuers, and they offer different return opportunities for investors.
“Since many EM issuers borrow in foreign currency, their levels of capital account flows, current account and debt servicing needs are what matter for EM external liquidity,” Hepworth says. “To that extent, we believe higher quality, investment grade credits that can finance themselves or have market access offer the highest conviction for positive total returns in the short term, including countries such as the Philippines, Peru, Qatar and Israel.”
Central bank support
These countries could also benefit from external support measures. While G3 central banks have not included EM in their bond-buying programmes, PGIM Fixed Income believes higher quality issuers will be second-degree beneficiaries. “What is less clear are the support measures from the G20 to avoid defaults in weaker credits,” adds Hepworth. “Our base case assumes that additional steps will be taken to prevent liquidity stress from morphing into solvency issues. One possibility is the extension of advanced economy swap lines with more EM central banks, especially in the fast-growing and large Asian economies.”
Within Asia, hard-currency investment grade Asian sovereign and quasi-sovereign issuers appear reasonably priced, Hepworth says. However, those that issue infrequently, yet are fundamentally healthy, will perform best in an environment of increased supply, she adds, citing opportunities in select high yield sovereigns where pricing reflects the risk, such as shorter-dated Sri Lankan debt.
On local currency opportunities, PGIM Fixed Income favours issuance from China, South Korea, Thailand, India and Indonesia – countries that may be poised to reduce interest rates to stimulate growth.
“Low inflation and wide output gaps are the main reasons we continue to believe in the potential outperformance of these countries over their developed market counterparts,” she explains, adding that China, South Korea and Thailand are facing deflationary forces. India and Indonesia also look attractive. “Despite the negative impact of wide current account deficits, and current low inflation, they may reduce rates to support lagging economic growth,” says Hepworth. She also sees opportunities in high yield Indian credits, particularly in the renewable energy sector.
China’s inclusion in various global bond indices also bodes well for its local bond market, Hepworth says.
Some of the world’s major bond index compilers – including Bloomberg Barclays and JP Morgan – have begun to include Chinese bonds in their gauges, which means that demand for China’s bond will increase. In the corporate sector, PGIM Fixed Income favours larger, strategically important Chinese state-owned enterprises where spreads remain attractively wide compared with pre-crisis levels.
However, PGIM Fixed Income identifies two concerns for China: risks in its global supply chains and rising tensions with the West.
China’s extended lockdown period in response to the virus, which was first detected in Wuhan, has led to some companies moving their global supply chain management away from China.
“Even as economic activity rebounds, which is our baseline, firms may well seek to diversify the global dimensions of their production to avoid inordinate dependence on any single country,” says Hepworth.
However, any diversification of supply chains away from China is also likely to benefit other Asian economies, though, at the cost of at least temporary inefficiencies, she adds.
Another risk PGIM Fixed Income is monitoring is the increased geopolitical tension between Western powers and China. “China’s delay in releasing information about the Covid-19 outbreak in the city of Wuhan has resulted in substantial criticism from other countries,” says Hepworth.
Helen Chang CFA
Head of Asia Pacific ex Japan
Client Advisory Group
PGIM (Hong Kong) Limited
T: + 852 3769 8283 M: + 852 6898 0982
The information represents the views and opinions of the author as of June 3, 2020, is for informational purposes only, and is subject to change. 2020-3254