Maybe it’s an optimistic time of the year or maybe it’s just a good investment case? Whatever you identify as the driver, there is no denying that 2023 has begun in extraordinary fashion for emerging markets debt (EMD).
According to Barron’s1, emerging market nations placed US $39 billion in bonds during the first two weeks of this year, nearly half the total for all of 2022. The surge prompted the Financial Times2 to remark that investors were ‘piling into emerging markets’ and it noted that the speed of cross-border flows [into EM assets] was now ‘second only to the stream that followed the lifting of coronavirus lockdowns in late 2020 and early 2021.’
In reality, there are a number of quite rational reasons why investors have become more attracted to EM debt.
The beginning of a bounce-back
Rising interest rates in developed markets meant that part of the flows that would normally be ‘searching for yield’ in EM markets stayed local in 2022. Further, the war in Ukraine triggered uncertainty and reigned in investors’ appetite for risk, contributing to significant spread widening with EM bonds. And the strength of the US dollar has a disproportionate impact on EM currencies, placing pressure on exchange rate pegs and feeding into inflation through higher dollar-priced food and energy. This all hit the EM debt markets hard.
Overall, the decline in US treasuries in 2022 eroded over half of the return for emerging market hard currency sovereign bonds. 2023 is seeing the beginning of a bounce-back from those effects.
With US monetary policy now already highly restrictive, interest rate volatility is expected to be dampened as the US Federal Reserve approaches its peak rate. Investors are looking beyond that towards stable and then declining global real rates and this supports risk assets, including EM debt.
China’s transformation from headwind to tailwind
From the perspective of positive influences, as opposed to a lessening impact from negative pressures, China’s re-emergence from its zero-Covid policy is expected to be a huge driver of macroeconomic support for many EM countries. Chinese authorities have already had success in stabilising the country’s property sector and the prospects for a recovery in consumer demand also bode well.
China’s reopening puts it in a different stage of the growth cycle to other countries as pent-up demand from lockdowns is still waiting to be fulfilled. We expect this should boost growth to around 5.5% this year, which would make China one of only a handful of countries expanding in 2023. Given the trade linkages China has to other EM economies, this is an important pillar of support to the asset class as developed market economies slow and even go into recession.
A supportive technical backdrop
EM bond yields (as measured by the JPMorgan Emerging Market Bond Index) are at levels in line with or better than anything on offer over the last decade3. In addition to the nominal value of this return, the elevated level of yield provides a buffer of sizeable compensation in the event of short-term spread and/or US treasury price changes.
J.P Morgan EMBI Global Blended Yields
Source: Macrobond and Columbia Threadneedle Investments
From a technical perspective, after a year of heavy outflows last year many investors are under exposed to EM debt and on the supply side, while issuance obviously has picked up, the net supply picture is still supportive.
A few grey clouds will always linger
This is not to say that 2023 will be without challenges. The tight monetary policy, recession and fiscal drag in developed markets will serve to compromise growth in EM countries this year, although we nevertheless expect the expansion of EM economies to continue with the EM/DM growth differential widening again.
Geopolitics also remains a notable risk. The Ukraine conflict continues to threaten supply chains and global stability while China/US tensions remain heightened. Elsewhere, the escalation of protests in Peru, resulting in a rising death toll, are a serious concern. Brazil is not out of the woods yet either regarding the potential for public unrest.
Opportunities for the risk-aware
When all is said and done, however, EM debt offers the risk aware investor an attractive investment yield and a wide and important diversification opportunity. In our portfolios, we have increased our overall risk position, reduced the duration underweight and assigned more balanced risks to bond yields.
With spreads across the credit-quality scale having retraced much of 2022’s widening, we do not expect further significant spread compression this year and therefore continue to seek relative value opportunities where idiosyncratic factors could be powerful drivers of return.