There are two sides to every sell-off. With emerging market debt (EMD) posting its weakest H1 return since the height of the global financial crisis, investors must decide whether to approach this sell-off as a setback or a shopping spree. On the one hand, EMD is down 21.76% year to date¹, having borne the brunt of the post-Covid economic malaise and the impact of Russia’s war in Ukraine. On the other hand, valuations are at a level of attractiveness that fixed income markets seldom see, particularly given the lack of idiosyncratic risks and low rate of default among the countries themselves.
EMD investors, therefore, find themselves at a fork in the road. Do they follow consensus and take flight, or grasp an unprecedented opportunity to build a long-term position in an asset class that has come of age and is still exposed to the structural drivers of global growth? Here, we look at the seven reasons why we believe investors should do the latter in H2.
1. Valuation: sale of the century?
Present valuations in the EMD space are largely in line with that of equities. Given that fixed income traditionally outperforms equities on the downside – by virtue of being a more stable, defensive asset class – the equal valuation footing upon which they currently stand suggests that EMD has been vastly oversold. As a result, investors with the bandwidth to accommodate more risk and believe in the long-term EM growth story, should consider current valuations as a unique buying opportunity.
2. Global challenges priced in
While few areas of the market have been untouched by Russia’s war in Ukraine, EMD has been among the hardest hit. Notwithstanding the human tragedy of Russia’s actions, we believe markets have now largely priced-in the global economic impact of the invasion. For this reason, we do not expect significant further economic fall-out as a result of the war. The outlook for inflation and global growth have been the other major drags on EMD performance year to date. Regarding the former, we believe that the US Federal Reserve (Fed) has finally shown its hand. With its tightening stance no longer an unknown, fixed income investors can begin to reassess their positions in light of the knowledge that inflation will likely be capped by Fed action in the medium term. Now that we know the general pace at which the Fed is likely to tighten policy, we are confident that a major global recession, similar to the global financial crisis, is unlikely. Overall, this supports the case for buying into EMD at current levels in anticipation of a more accommodative market environment in H2.
3. Idiosyncratic strength
While the global economy remains a challenging place for investors, there are few idiosyncratic risks coming out of EM countries themselves. Since the outbreak of Covid, and despite the great economic stress that has ensued, we have seen only one EM default on the hard currency side (Sri Lanka)². In line with wider evidence, this suggests that countries across the regions are increasingly well-managed and fully capable of servicing their debt. Distressed pricing in the asset class means there are potentially high returns on the table and, even if country-specific issues did arise, valuations are more than accommodating.
4. Commodity prices pick-n-mix
Many areas of the investment community still approach the emerging markets as a homogenous group of economies carrying more or less the same risks and rewards. In times of distress, an individualised approach to the countries that comprise the asset class is more important than ever. For example, energy producers are particularly well placed as we move through the second half of the year to benefit from supply constraints upholding prices. We are closely watching the oil exporters of the regions, who are likely to continue to benefit from elevated prices. Similarly, some of the Middle Eastern and Sub-Saharan African names, which were previously under strain (such as Angola, Bahrain, Oman and Gabon), took advantage of higher commodity prices to deleverage and reduce external vulnerabilities. In Latin America, the two biggest economies – Mexico and Brazil – are on the cusp of developed-market status and, despite seeing weak growth this year, sufficiently diversified and globally linked that they are able to withstand any headwinds to growth.
5. Tailwinds in H2
The second half of the year will see the main emerging economies clear key political hurdles that could ease some of the uncertainty hanging over EMD. The Brazil elections, and the 20th National Congress of the Chinese Communist party could stablise the political outlook and many investors are likely to return to the asset class in the fourth quarter as a result.
6. The DM-EM divide
With EM issuers, we have found country ceilings providing downward pressure on ratings. We are noticing comparable volatility rates and lower net leverage for EM names both in the high yield and investment-grade space, implying better credit metrics/credit health. We believe EM corporates are very much best of breed, with lower leverage and healthy EBITDA margins. We believe the strongest opportunities in EMD currently lie in the BB/BBB space, both on the sovereign and corporate side. Issuers in this band of the asset class tend to display ample free cashflow, and countries are largely well-run and generate fiscal surpluses.
7. Charting its own course in ESG
EMD is a tough asset class to implement effective ESG integration. Corporates and sovereigns across the emerging markets are at a much earlier phase in their ESG journey relative to their developed counterparts. In our view, this makes for a compelling opportunity for investors. As current global challenges ease, we expect resurgent interest in ESG-focused investments across the region and investors can benefit from identifying the most interesting names early. At Federated Hermes, we use our dynamic, proprietary ESG scoring methodology – specifically adapted to the nuances of the region – to capture positive trends and pinpoint names that are effectively balancing the needs of investors with the promotion of ESG themes.
1 JPM EMBI Global Diversified is down 21.76% year to date (market proxy to EM sovereigns); JPM CEMBI Global Diversified is down 15.22% year to date (market proxy to EM corporates). Source: Bloomberg, as at 19 July 2022.
2 We do not include Russia’s involuntary default in this analysis.