Beyond headline events

Looking ahead, we regard the risks as balanced for the overall emerging market (EM) debt asset class, although there are many opportunities on a country-by-country basis. Rather than a top-down approach to market beta, capturing market inefficiencies will require a nuanced approach based on active country selection, which has already been the case in recent months given a wide dispersion of returns across markets.

From a valuations perspective, we continue to believe that there are more compelling opportunities in EM high yield (HY), which offers attractive spreads and reduced sensitivity to US Treasuries. EM investment grade (IG) is typically more sensitive to movements in the US Treasury market, while we consider valuations are stretched as spreads currently trade below their 10-year average. Further down the capital structure, we continue to take advantage of idiosyncratic risk/reward opportunities within EM HY, investing in countries that are on a path towards longer-term structural economic improvements, potentially leading to a re-rating opportunity - El Salvador’s recent upgrade being one example.

In-depth analysis and untangling market complexities

Nevertheless, we will need to exercise careful judgement and discretion when choosing countries in the more distressed area of the market. One hurdle will be the pick-up in EM HY sovereign amortizations in 2024. Bond market access to the lowest-rated borrowers remains constrained due to tight global financial conditions, which may result in countries having to deplete their reserves to meet payment obligations. Countries will also be more reliant on multilateral or bilateral support for their refinancing needs, a trend that has been seen over the past year.

Our overall expectation is that EM countries will muddle through to meet short-term liquidity needs, although the longer-term outlook for the most economically vulnerable countries remains more uncertain. Rigorous fundamental analysis will be essential to avoid a credit event and/or potential default, with a country’s liquidity, solvency and willingness to pay being critical inputs to the country selection decision, all of which need to be evaluated against the political and economic framework. We will also be monitoring developments on the G20’s Common Framework in debt restructuring negotiations, as well as any possible shifts in the legal framework relating to the comparability of treatment for private creditors.

Another consideration is the complexity of the market environment, as rising geopolitical risks and protectionism are contributing to a more fragmented global economy. In terms of market pricing, the war in Ukraine is well understood by investors, while the Middle East conflict has so far remained localized with a limited market impact. However, the wider spillover effects remain a potential tail risk in the Middle East, especially if there is any further escalation in hostilities. A higher oil price would be the most expected outcome under this scenario, with EM oil exporting countries more likely to be resilient.

Protectionism through the implementation of trade policies to secure national interests and diversify supply chains, such as in energy and technology, is also reshaping the global economy. EMs that are strategically aligned to developed economies – Mexico being a clear example – should continue to benefit from this trend. Ultimately though, the stability and advancement of global growth will depend on cooperation between the two largest economies, the US and China. The recent meeting between Presidents Biden and Xi Jinping has been a small, but important, step in starting to reset relations. At the same time, China’s growth trajectory is showing signs of stability with the help of policy support as the country’s economy rebalances towards services. We are mindful, though, that the US Presidential election in 2024 could reignite trade-war rhetoric, generating headline noise and market volatility.

Building a diversified portfolio

Risk management through diversification will be a key investment tool, and this will mean looking beyond the index for capital appreciation opportunities. In local-currency sovereign bonds, we favor Latin America and Eastern Europe versus lower-yielding Asia, although cognisant of inflation risks and being more selective on relative value as the rate cycle has progressed. While our base case remains that core inflation will continue to come down, the path might be slower and not so linear. Elevated real-rate buffers and a softening growth momentum across EM countries continue to support measured policy rate cuts, but the easing cycle is likely to be more gradual given potential commodity price volatility. Higher oil prices have already slowed the disinflationary cycle, but the impact of El Nino on food prices, which has been muted so far, will be another consideration moving through the winter/spring season.

Elsewhere across the EM universe, EM corporate bonds still offer compelling spread over the EM sovereign curve, especially among BBB- and BB-rated sectors, and over the US corporate curve in these ratings categories, as well as among B-rated issuers. Companies have conservatively managed balance sheets (the obvious exception being China property developers) and early indications from the third quarter earnings season point to reasonable levels of profitability and stable leverage.

The impact of global events on EM risk sentiment may continue to divert capital away from the asset class, especially when the risk-free rate offers a substantial yield. However, as we move further through the US Federal Reserve cycle over the next year, we should see capital return to the asset class, which offers investors a broad and differentiated opportunity-set of higher-yielding sovereigns, quasi-sovereigns and corporates.