EM Debt: Uncovering Opportunities in a Market Rife with Risk
With a number of risks facing emerging markets today, capital allocation is difficult and often a function of an investor’s appetite—but opportunities do still exist.
2022 has been a difficult year for all risk assets. From rising rates and inflation, to recession concerns in the U.S. and Europe, to geopolitical conflicts, the challenges facing markets weighed on performance in the third quarter, with emerging markets (EM) sovereign, local and corporate debt ending in negative territory. Spreads widened further across the EM debt asset class, while ongoing outflows continued to challenge liquidity conditions in the market.
Breaking Down the Risks: Inflation, China & the IMF
While some of the risks facing EM are intertwined with the broader market, others are more specific to the asset class. One of the most topical relates to the U.S. Federal Reserve’s (Fed) quantitative tightening (QT) policy, the effects of which are arguably less understood, and less scrutinized, than the central bank’s rate-tightening agenda. Under QT, we estimate global money supply could shrink by as much as 5% over the next year—and as a result, we believe it is plausible that inflation could fall below 2% by the end of 2023. While this is less a forecast about what will ultimately transpire—and more an attempt to highlight where the market may have a blind spot—under this scenario, one could make the argument that the Fed is at risk of making a major policy mistake by continuing to raise rates into an environment where inflation is set to fall.
Another significant risk facing EM relates to the International Monetary Fund’s Common Framework. Since the pandemic, a number of EM countries have been encouraged to seek financial assistance under this framework. In some cases, as a condition of receiving financing, countries are being encouraged to restructure their debt or default—even if they are capable of meeting their debt obligations. This is problematic for a few reasons. For one, incentivizing countries to default effectively weakens the basic rights of bondholders. The long-term implications for EM countries are perhaps even more problematic, as restructurings can have significant implications for accessing capital markets in the future—a critical component in the development of emerging nations.
China is another source of uncertainty facing emerging markets. From our perspective as managers, the situation in China has become one in which economic considerations are increasingly taking a back seat to political considerations. We saw this toward the end of 2021, when the government allowed the property sector—which accounts for over 25% of the country’s total GDP—to undergo a significant correction. The stated goal of unifying China and Taiwan, even amid threats of sanctions and other punitive measures, further underscores the precedence given to political considerations. At the same time, there are concerns that China’s economic growth may be slowing, and questions about what they may mean for the rest of the EM debt universe.
Sovereign & Local Debt
While this backdrop is certainly difficult, there are bright spots to be found. On the local debt side, many EM central banks have raised rates aggressively to combat higher inflation and, in cases where inflation seems to be peaking, may be nearing the end of their hiking cycle. With real rates in many of these countries now positive, we believe select opportunities could emerge with certain local rates given the potential carry on offer. While local currencies have faced greater challenges in this environment, there are potential benefits to a currency overlay strategy, which can put investors with existing EM exposure in a position to generate alpha without taking significant market beta risk. This type of strategy effectively removes the directionality of the U.S. dollar position, and relies on analysis of country financials to identify currencies that look poised to perform well over time.
From a hard currency perspective, until global interest rate risks and inflation show signs of stabilizing, the environment for credit is likely to stay volatile. For this reason, and with the understanding that things could deteriorate further before they improve, we see benefits to staying up in quality and focusing on issuers that can withstand further uncertainty. Specifically, we see value in certain Latin American countries that have diversified, competitive and well-run economies such as Costa Rica, Dominican Republic and Brazil. Very select single-Bs also look potentially attractive, but given that many high yield countries have essentially been cut off from external funding markets, ensuring that these countries have alternative sources of financing, or the ability to adjust fiscally, is paramount.
In the EM corporate debt space, high inflation will likely create further cost pressures going forward, leading to some weakness in profit margins and a slight deterioration in leverage metrics. On the positive side, however, most EM corporates are coming from a strong starting point—revenue and EBITDA are back to pre-pandemic levels for many issuers, and leverage levels remain in reasonable territory, around 1.8x for high yield companies and 1.0x for investment grade issuers.1 Against this backdrop, while defaults are expected to increase next year, we believe they will remain around 2–3% (excluding China, Ukraine and Russia)2. So while there may be some weakness going forward, we expect it to be manageable.
The outlook for slower-but-positive economic growth across most EM countries should also continue to support the corporate landscape. That said, we are keeping a close eye on growth expectations for developed markets as well. A deeper or longer recession in the U.S. and/or Europe—to the extent that it could trigger outflows across developed market fixed income asset classes—could have a contagion effect on EM corporates, leading to increased outflows and potential liquidity challenges.
Figure 1: EM vs U.S. High Yield Corporate Net Leverage
Source: J.P. Morgan. As of June 30, 2022.
In this environment, we believe staying up in quality makes sense. Within the investment grade space, BBBs look particularly attractive, especially those from Latin America, Asia ex-China, and Gulf Cooperation Council (GCC) countries. A number of corporates from these countries are commodity-producers, and continue to benefit from the supply disruption—especially the low-cost producers in Argentina, Brazil and Uruguay. In the high yield segment, we see value in BBs in Latin America, and Asia ex-China also looks interesting. We also have a continued preference for short duration debt given that it is less correlated with rate movements, and therefore can provide less volatility if inflation and higher rates persist. From a sector perspective, there is a case to be made for being more defensive—rotating out of cyclical and lower-quality names, and into more stable industries such as utilities and technology, media and telecom (TMT). We also see select opportunities in the banking sector, as banks tend to benefit from a rising rate environment.
In this challenging environment, with many unknowns on the horizon, rigorous credit and country selection will continue to be a differentiator in performance. Ultimately, managers that closely assess risk, and take a bottom-up, fundamental approach to investing, will likely be best positioned to uncover opportunities.
1. Source: J.P. Morgan. As of June 30, 2022.
2. Source: JP Morgan Corporate Default Monitor. As of August 10, 2022.