Navigating the rocky path to emerging market returns
EM economies have been notably resilient for much of the past year as developed markets (DM) have suffered under the strain of persistently high inflation, among other drags on growth. More recently, the challenging macro backdrop globally has started to put some developing markets under increasing stress. Yet valuations, positioning and technicals across EM debt still appear broadly supportive, requiring investors to keep a sharp eye on opportunities.
“Many EM central banks started hiking ahead of DM central banks. But now, most EM countries are reporting lower-than-expected inflation, so investors expect more interest rate cuts soon. At the same time, local currency yields remain substantial,” said Mariusz Banasiak, managing director and head of local currency rates and FX for PGIM Fixed Income's EM debt team.
In short, the firm’s strategy is to minimize vulnerabilities while remaining focused on the potential that exists within the EM debt universe.
For now, this means favouring hard currency sovereigns and quasi-sovereigns with solid fundamentals and government support. It also involves an overweight position on BBB/BB corporates in economically stable countries. Further, the firm is gaining confidence in local rates as cuts approach, but has a cautious stance on EM currencies on risks of slower growth.
Cautious optimism
The pathway ahead from today’s global environment of higher rates, looming recessionary fears, decelerating growth scenarios and relentless uncertainty, remains unclear.
As a result, EM debt investors must continue to ask key questions to help shape their allocations for the rest of 2023, and beyond. In particular, they need to identify the weak links in the sector, given the extent of leverage of EM to global growth, funding conditions and US dollar strength. Further, sentiment will depend on the probability of more defaults due to the associated risks.
“The carry in EM debt is high and price returns can also be attractive if the US economy manages a soft landing,” explained Banasiak.
He also believes that China’s growth outlook can remain a tailwind regardless of any possible US-led sanctions. At the same time, the trend of “reshoring” may bring opportunities in Asia and Latin America.
More broadly, even despite geopolitical tensions, support from multilateral organisations and development banks promises to aid EM sovereign debt restructurings and prevent drawn-out defaults.
Riding on resilience
Being nimble has been essential to the success of the PGIM Fixed Income EM debt team over the past 12 to 18 months.
The high carry helped the asset class through turbulent times in the first half of 2022 as the US Federal Reserve (Fed) embarked on its historic and rapid interest rate hiking cycle. By comparison, however, some of the EM central banks – especially those in Latin America and some in Eastern Europe – hiked rates much higher.
This partly fuelled positive returns across all EM sectors, explained Banasiak. “Credit saw excess returns. Returns for EM currencies were also notable, with a lot of that due to high carry in Latin America.”
An important dynamic in the overall performance of EM was the fact that a lot of the continued Fed hiking was priced in.
In response to the economic and investment landscapes in 2022, PGIM Fixed Income’s EM debt team initially took a defensive view on the market due to its expectations that the tighter monetary policy amid the projected economic slowdown would see risk premiums rise. “We were conservatively positioned in EM credit, finding attractive bottom-up opportunities, as well as upping quality positions,” explained Banasiak.
In rates, the team was worried about inflation due to its view that some central banks were behind the curve, he recalled. In the currency space, meanwhile, since the US dollar usually benefits from slower growth and tougher policy, the PGIM Fixed Income EM debt team held short positions in select currencies, especially in Asia.
As last year continued, the firm became a lot more constructive on EM, said Banasiak. It adjusted its positioning in response to signalling by the Fed about a reduction in the pace of hikes, as well as the unexpected rebound in China as Covid restrictions were lifted and policies to support the property market were unveiled.
The firm’s subsequent EM allocations included going long credit in its preferred segments, focusing on relative value plays in rates rather than a short duration bias, and unwinding all short EM FX exposure.
Adapting with a selective EM stance
It was mostly the shock to the US banking sector that added unexpected stress in the first few months of 2023. The subsequent volatility has impacted EM, which is expected to suffer along with DM in the short term.
Yet over a 12-month horizon, with expectations the Fed will need to cut rates at some point to stabilise the economy, global financial conditions and global growth prospects are likely to improve. “Historically, EM will benefit in this scenario,” added Banasiak.
These dynamics also reinforce the fact that investors must assess EM as a bifurcated opportunity set, especially on the credit side.
For instance, 50% of the investable universe is investment grade, with strong credit fundamentals, while along the BB spectrum, the range shifts markedly from high to low quality credits. “[Investors need a] deep understanding about political risk and relationships that these countries have with multilateral organisations,” added Banasiak.
As of early June 2023, the PGIM Fixed Income team upgraded its view on EM corporate bonds. It cited a mix of factors: the global macroeconomic backdrop; the underperformance and better relative value of EM corporates versus DM peers plus EM sovereigns; falling forecasts for net issuance for the remainder of 2023; and defensive investor positioning, especially in lower-quality segments.
In the local currency space, the firm has seen government bonds continue to perform well, with yields now around 50 basis points tighter than at the start of this year.
In currency markets, volatility has continued to fall, in turn boosting EM currencies. “High-carry EM currencies hold an obvious attraction for investors,” explained Banasiak, but added that the performance of low-carry EM currencies, such as the Chinese yuan, has been mixed as DM and EM monetary policies diverge. “We maintain our long US dollar bias, which may benefit from the absence of Chinese stimulus to date and from slowing economic data in EM.”