Public Fixed Income

EMD: Light at the End of the Tunnel

January 2021 – 4 min read
The rollout of the COVID vaccine may be slower across emerging markets, meaning restrictions will likely remain in place for the foreseeable future. But there are bright spots—including in local currencies and companies that have adapted to this ‘new normal’.

Emerging markets (EM) debt continued to gain ground in the fourth quarter as news of the vaccine and higher commodity prices jumpstarted the rally that had begun to slow toward the end of the third quarter. Encouraging data out of China, a key driver of EM economic prospects, also contributed. Capping off a year that saw sell-offs rivaling some of the largest in history, sovereign, corporate and local debt ended the year in positive territory, returning 5.26%, 7.13% and 2.69%, respectively.1 Spreads tightened across the board, retracing nearly all of the widening experienced at the onset of the pandemic. Even currencies, which have lagged through the recovery, saw a small bounce-back—but they remain well-below pre-pandemic levels.

FIGURE 1: EM DEBT YEAR-TO-DATE PERFORMANCE

Source: J.P. Morgan. As of December 31, 2020.
 

Local Currencies: A Bright Spot Ahead?

While EM currencies are still lagging overall, a number of tailwinds have emerged that could create a potentially compelling opportunity in the asset class going forward. For one, many emerging markets, because they have faced weaker consumption as well as outflows on the heels of the pandemic, have been running smaller account deficits in aggregate—with some countries now running current account surpluses. In countries like Brazil, Mexico, South Africa and Indonesia, for instance, deficits have either significantly narrowed or turned into surpluses. Essentially, this means the financial needs of EMs have come down, or in other words, their balance sheets are in better shape. At the same time, exports from many EM countries have performed much better than expected as demand for commodities proved to be fairly resilient and underwent significant recoveries in the second half of 2020—helped by sustained demand from China. 

This combination of factors, in our view, suggests the forces may be in motion for currencies to reverse their underperformance in the months and year ahead, particularly if flows return to emerging markets. As follows, we believe EM local currencies currently offer significant upside potential.
 

Sovereigns: Continued Divergence

On the credit side, EM sovereign debt continues to face challenges, though the effects of the pandemic have varied widely from country to country. Generally speaking, downgrades and defaults have remained below initial expectations—and the rollout of the vaccine, coupled with higher commodity prices, should help keep defaults measured in the coming year. On balance, we continue to see particular value in countries that are investment grade-rated, including Columbia, Mexico, Romania and Brazil—a country that we rate internally as investment grade. On the high yield side, we remain focused on avoiding countries where financing measures are deteriorating. However, we do see select opportunities in countries like Ukraine, which has managed the crisis relatively well.

That said, while fourth quarter performance was broadly strong—and spreads at the index level retraced all, or nearly all, of 2020’s widening—there was sizable dispersion in the total returns on the debt of the 70+ countries in the J.P. Morgan EMBI Global Diversified (EMBIGD) index. Indeed, some countries’ debt ended the year in positive territory, while other countries substantially underperformed. That is to say, country selection matters, and it matters a lot. Particularly in an environment wrought with unknowns, EM sovereign debt should not be thought of as a beta asset class—rather, it is an asset class with great diversity of opportunity, but one that requires active management to select the right credits and, perhaps more importantly, avoid the wrong ones.
 

Corporates: Adapting to the New Normal

Like their developed market counterparts, EM corporate debt suffered indiscriminately at the onset of the pandemic but shortly thereafter staged an impressive comeback as stimulus and other relief measures provided a much needed lifeline—not only from the Fed and ECB but also from EM central banks and governments. Signs of a more sustained recovery in commodity demand from China later in the year provided further support to the asset class. 

While the vaccine news did advance the rally in the fourth quarter, there remain high execution risks with the governments’ rollout of the vaccines, with many EM countries not expected to reach scale in their rollout programs until the second half of this year. Most likely, EMs will lag their developed market counterparts, suggesting COVID-induced restrictions could remain in place in some countries for a while longer—albeit with a bit more light at the end of the tunnel. To that end, it remains crucial to identify those business models that are resilient enough to withstand an extended period of softer demand, or are able to adapt to the new normal. We continue to see value in companies in defensive sectors like utilities, consumer and telecom, media & technology (TMT), for instance. Corporates with innovative business models that are exposed to structural trends across EMs—including e-commerce and food delivery companies—also look more resilient. In fact, we are already seeing new issues and new supply from these types of companies, and expect to see more in the months and year ahead. Conversely, companies in the COVID-sensitive transport sector—from airports and airlines to highways—and gaming companies may continue to face challenges.
 

Key Takeaway

There are certainly bright spots across the EM universe, and we expect to continue seeing opportunities as the vaccine is deployed and economies around the globe begin to open back up. Nonetheless, there is no shortage of risks facing EM sovereigns and corporates—from political tensions to the longer-term potential for rising rates in developed markets, as well as the reduction in support measures such as bank moratoriums and regulatory forbearance measures, which could present potential risks to the market. In this environment, active management, coupled with a bottom-up approach to identify the most resilient countries and credits, remains paramount.
 

1. Source: J.P. Morgan. As of December 31, 2020.

Omotunde Lawal, CFA

Head of Emerging Markets Corporate Debt

Cem Karacadag

Head of Emerging Markets Sovereign Debt

Dr. Ricardo Adrogué

Head of Global Sovereign Debt & Currencies

Any forecasts in this material are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Investment involves risk. The value of any investments and any income generated may go down as well as up and is not guaranteed by Barings or any other person. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Any investment results, portfolio compositions and or examples set forth in this material are provided for illustrative purposes only and are not indicative of any future investment results, future portfolio composition or investments. The composition, size of, and risks associated with an investment may differ substantially from any examples set forth in this material No representation is made that an investment will be profitable or will not incur losses. Where appropriate, changes in the currency exchange rates may affect the value of investments. Prospective investors should read the offering documents, if applicable, for the details and specific risk factors of any Fund/Strategy discussed in this material.

Barings is the brand name for the worldwide asset management and associated businesses of Barings LLC and its global affiliates. Barings Securities LLC, Barings (U.K.) Limited, Barings Global Advisers Limited, Barings Australia Pty Ltd, Barings Japan Limited, Baring Asset Management Limited, Baring International Investment Limited, Baring Fund Managers Limited, Baring International Fund Managers (Ireland) Limited, Baring Asset Management (Asia) Limited, Baring SICE (Taiwan) Limited, Baring Asset Management Switzerland Sarl, and Baring Asset Management Korea Limited each are affiliated financial service companies owned by Barings LLC (each, individually, an “Affiliate”).

NO OFFER: The material is for informational purposes only and is not an offer or solicitation for the purchase or sale of any financial instrument or service in any jurisdiction. The material herein was prepared without any consideration of the investment objectives, financial situation or particular needs of anyone who may receive it. This material is not, and must not be treated as, investment advice, an investment recommendation, investment research, or a recommendation about the suitability or appropriateness of any security, commodity, investment, or particular investment strategy, and must not be construed as a projection or prediction.

Unless otherwise mentioned, the views contained in this material are those of Barings. These views are made in good faith in relation to the facts known at the time of preparation and are subject to change without notice. Individual portfolio management teams may hold different views than the views expressed herein and may make different investment decisions for different clients. Parts of this material may be based on information received from sources we believe to be reliable. Although every effort is taken to ensure that the information contained in this material is accurate, Barings makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information.

Any service, security, investment or product outlined in this material may not be suitable for a prospective investor or available in their jurisdiction. Copyright in this material is owned by Barings. Information in this material may be used for your own personal use, but may not be altered, reproduced or distributed without Barings’ consent.

Related Viewpoints