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7 reasons to not overlook emerging market debt

A recent turnaround in EM debt performance could bring greater attention to all the underlying strengths of this asset class.

06/05/2024
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Authors

Autumn Graham
Credit Analyst, Emerging Market Corporates, Fixed Income Research

At a time of heightened geopolitical uncertainty, some investors may have reservations about increasing allocations to emerging market debt (EMD). Before acting on such an assumption, though, it’s important to have a deeper understanding of what is happening in this asset class and the many ways it has structurally changed in recent years. In our view, a combination of factors are suggesting now could be the ideal time for adding new, or increasing existing, allocations to emerging market debt.

1. Emerging market debt often does well in the years after the Fed reaches the peak of a rate-hiking cycle.

Historically, the end of a rate-hiking cycle by the US Federal Reserve (Fed) has set the stage for strong performance from EMD. Already, there are signs that today’s markets could follow this pattern. On a hard currency return basis, the rebound in EMD seems to have already begun, while on a local currency basis, the recovery has yet to accelerate, but returns have moved out of negative territory. (See Figures 1 and 2)

A recovery in EMD returns since the Fed’s latest rate-hiking cycle ended in July 2023

Figure 1: EM hard currency returns rebased from last Fed hike

v3_Opps in EMD_1296pxW_Fig 1_top

Figure 2: EM local currency returns rebased from last Fed hike

v3_Opps in EMD_1296pxW_Fig 2_bottom

Figure 1 & 2: EMBI Global Diversified Index total returns since last Fed hike. Source: Schroders, Bloomberg, as of March 13, 2024. Past performance provides no guarantee of future results and may not be repeated.

This pattern of EMD posting strong returns in the aftermath of Fed rate hikes became well-established over the past 30 years, as Figure 3 shows. During that three-decade period, EMD experienced negative returns in just seven years, as reflected by the returns of the JPMorgan EMBI Global Index. After each of the downturns in the ’90s, ’00s and ’10s, EMD delivered a strong and sustained recovery for multiple years.

Figure 3: Down years in the midst of a crisis were usually followed by multiple strong years

Annual EMBI Global Index returns, year-over-year, as a percentage

v2_Opps in EMD_1296pxW_Fig 3

Source: Schroders, LSEG Datastream, ICE Data Indices; JP Morgan 2023. Shown for illustrative purposes only and should not be interpreted as investment guidance. Past performance provides no guarantee of future results and may not be repeated.

2. Emerging markets currently have healthier fiscal conditions than developed markets.

The average ratio of government debt to gross domestic product (GDP) is much healthier now in emerging markets, as Figure 4 illustrates. For developed markets, these ratios exceed 100%, on average. For emerging markets, the percentage of government debt to GDP is much lower, at just above 60%. If you exclude China, which does have a serious debt problem and will need to exercise better fiscal discipline to address it, the average federal-debt-to-GDP ratio for the rest of emerging markets (EM) is below 60%. To demonstrate how much these debt ratios confound the usual assumptions investors often have about all emerging markets, consider that in 2016 the US and Mexico had the same federal-debt-to-GDP ratio of 60%. In the years since, Mexico has exercised the fiscal discipline to keep that ratio at 60%, while the United States’ debt on this score has ballooned to 120%.

Figure 4: Emerging Markets remain broadly healthy

Average government debt as a percentage of GDP

v2_Opps in EMD_1296pxW_Fig 4

Source: IMF Fiscal Monitor, as of April 2023. Shown for illustrative purposes only and should not be interpreted as investment guidance.

The levels of debt being serviced by the United States and the Eurozone currently may not be sustainable. Emerging markets may offer an attractive opportunity for investors who want to diversify away from the risk created by those burdensome debt levels in the developed markets (DM). Emerging markets undeniably went through a difficult period amid the supply chain disruptions brought on by the pandemic and the resulting high inflation. The higher prices for all products, and food and energy in particular, had a dramatic impact in EM countries. But now inflation across the globe has come down, and one could argue that emerging markets have benefitted even more than DM from the normalization in food and energy prices. In emerging markets, relative to DM, food and energy constitute a higher percentage of the basket of goods and services that are used to calculate each country’s Consumer Price Index (CPI). The combined favorable scenarios of lower inflation and manageable debt levels may explain why many central banks across EM are already in a rate-cutting mode.

3. EM debt has emerged from the interest rate reset of 2022 with strong performance.

For the one-year period through the end of February 2024, EM debt, has posted a total return of close to 10%. In doing so, it has outperformed all other major categories of fixed-income except US high-yield bonds, as Figure 4 shows.

Figure 5: EM debt is outperforming other fixed-income sectors

12-month total returns through February 29, 2024

v2_Opps in EMD_1296pxW_Fig 5_HOLD OFF for now_data to come

Source: Bloomberg, JP Morgan as of February 29, 2024. Charts are for illustrative purposes and should not be viewed as a recommendation to buy or sell. Indices provided in the chart above are as follows: EMD Blend: JP Morgan EM Equal Weight Index; US IG: Bloomberg US Corporate Investment Grade; US HY: Bloomberg US Corporate High Yield; US MBS: Bloomberg US Mortgage Backed Securities; Munis: Bloomberg Municipal Bond Index; Cash: Bloomberg US Treasury Bills 3-6 months index. Past performance provides on guarantee of future results and may not be repeated.

4. Major global brands, not exotic names, represent a major component of EM corporate debt.

Many emerging market companies have well-known brands and a dominant share of their markets not only in their home countries, but also across their regions and, in numerous cases, around the globe. The world-class EM companies come from sectors as diverse as semiconductors, financial services and energy. EM firms have also proven to be innovators and market share leaders in businesses such as internet commerce, green energy, food production and logistics.

Just as governments across the emerging markets have kept their debt levels low, EM companies with investment-grade debt are, on average, keeping their debt at lower levels than their developed market counterparts are, as Figures 6 and 7 show. Some of this stems from the fact that these companies recognize that, because they are headquartered outside the United States, they must operate with lower debt loads and higher cash balances than US and European companies in the same credit-ratings category can. The EM companies do this to buffer their balance sheets against any potential disturbances caused by interest rate fluctuations or volatility in currencies and the capital markets. That conservative approach to debt acts as an additional safeguard for these companies in a highly dynamic economic climate.

EM companies, on average, are keeping their debt at lower levels than their EM counterparts

v2_Opps in EMD_1296pxW_Fig 6 and 7_sideXside

Source: Schroders, JP Morgan, 2023. Shown for illustrative purposes only and should not be interpreted as investment guidance.

5. EM is benefitting from structural changes in global relationships.

The deglobalization trend, as companies look to diversify their suppliers beyond China, is occurring along with other major structural changes in global relationships. While China and the US are decoupling and forming new business and trading partnerships with countries across emerging markets, many EM countries are also forging new ties with each other and no longer relying on the world’s economic powerhouses as financial intermediaries.

As an example of this, the Abu Dhabi National Oil Company recently made a $2.2-billion bid for a 38.3% stake in Braskem, the Brazilian-based firm that is the largest petrochemical company in Latin America. It did so in an effort to diversify its revenue streams and find another major market that could be a source of demand for its oil products. For similar reasons, the Saudi Agricultural and Livestock Investment Company (SALIC) now has a more than 30% stake in the Brazilian meat company Minerva Foods. Saudi Arabia imports 70% of the red meat its citizens consume. The investment in Minerva supports Saudi Arabia’s stated goal of enhancing its food security. In turn, these investments have enabled Minerva to grow its business and diversify its product lines.

We believe this trend toward expanded and strengthened relationships across EM will only continue to accelerate over the next 10-20 years. These new, direct relationships, without US banks serving as intermediaries, strengthen the economic outlook for emerging market countries and the growth outlook for companies based in these markets.

6. The fundamentals of EM debt are well poised for the 3D Reset

Amid the regime shift that is being driven by the “3 Ds,” emerging markets appear to be well positioned for each of these megatrends. In fact, 60% of the weight of the EMD blended index has the potential to benefit from at least one of these trends.1

  • Decarbonization: Several emerging market countries rank among the world leaders in the global effort to be less dependent on fossil fuels. China ranks number one for installed capacity to generate renewable energy.2 India ranks number four. EM countries are also the world’s leaders in mining the minerals that are essential to the batteries that will propel electric vehicles. Chile, Peru and the Republic of Congo are the top three producers globally of copper. With nickel, Indonesia, the Philippines and Russa are the world’s top three producers. For lithium, Chile and the Republic of Congo rank, respectively, as the second and third biggest producers worldwide. (Australia, the number one miner of lithium is the only developed market to break into the top three for production of these minerals.)
  • Deglobalization: Even though countries and companies are aiming to have their supply chains not be entirely dependent on one emerging market country – China – other EM countries have benefited from these near-shoring and “China +1” strategies. Mexico and India have been the prime beneficiaries of the moves to be less reliant on China. Both Mexico and India are receiving massive investments in manufacturing capabilities, information technology services and more. Mexico is now the United States’ number one trading partner, and US companies like Mattel, Tesla and Lego are all building factories in northern Mexico. As an emerging market debt investor, there are multiple ways to pursue these opportunities, including real estate debt that could benefit from the booming industrial properties market in northern Mexico. Although they have not garnered much media attention for this, other EM countries like Hungary, Poland, Czechia and Indonesia are also benefitting from the deglobalization trend, albeit not on the same dramatic scale that Mexico and India have.
  • Demographics. While countries across both emerging and developed markets will be struggling with the challenges posed by an aging population and shrinking workforce, a number of EM countries, including China, Indonesia, Argentina and South Africa, are bucking those trends and stand to benefit from growth in their working-age populations. But EM countries are also developing and deploying the technologies that will help the world manage the shrinking workforce in many countries. A considerable amount of the innovative thinking that is needed to drive technological advancement is coming from emerging markets, as evidenced by the fact that nearly three fifths of the world’s patent applications in 2021 came from emerging markets. (See Figure 8.)

Figure 8: EM is leading innovation globally

Patent applications in 2021

v2_Opps in EMD_1296pxW_Fig 8

Source: Schroders, Visual Capitalist IAE, February 2023. Shown for illustrative purposes only and should not be interpreted as investment guidance.

While robotics have already transformed manufacturing, even more industrial automation will be needed as the human workforce continues to shrink globally. China is way ahead of the rest of the world in the number of installed industrial robots, as Figure 9 illustrates.

Figure 9: China dominates industrial automation

v2_Opps in EMD_1296pxW_Fig 9

Source: Schroders, Visual Capitalist IAE, February 2023. Shown for illustrative purposes only and should not be interpreted as investment guidance

7. EM constitutes high-quality investments

Credit-quality-conscious investors may be surprised to discover how much investment-grade debt is available in emerging markets. This higher-quality debt constitutes more than half of the major EM debt indexes, and, notably, more than two-thirds of the blended EMD index, as Figure 10 illustrates.

Figure 10. Investment-grade bonds represent more than half of EM debt index and more than two-thirds of the blended index

Percentage of each index that is investment-grade debt

v2_Opps in EMD_1296pxW_Fig 10

Source: Schroders, JP Morgan as of October 31, 2023. Shown for illustrative purposes only and should not be interpreted as investment guidance

Those concerned about investments in China may also want to take note of how small the weighting to China is in EM debt indexes. For the major debt indexes, that weighting is 10% or less, as Figure 11 shows. By contrast, China has a more than 25% allocation in the major EM equity index.

Figure 11: EM debt indexes have relatively small China allocations

China’s weight in various EM indexes

v2_Opps in EMD_1296pxW_Fig 11

Source: Schroders, JP Morgan, as of October 31, 2023. Shown for illustrative purposes only and should not be interpreted as investment guidance.

Historically, inflation rates have been a key concern for investors in emerging markets, but the real yields on the central banks’ policy rate are strongly positive now in most emerging markets. (See Figure 12.)

Figure 12: Real yields on sovereign debt are positive in most emerging markets

EM real policy rates (%)

v2_Opps in EMD_1296pxW_Fig 12

Source: Schroders, LSEG Datastream, ICE Data Indices; JP Morgan February 29, 2024. Current performance trends provide no guarantee of future results and may not continue.

Among corporate bonds, both in the investment-grade and high-yield sectors, EM bonds are also offering an attractive level of additional yield relative to their developed market counterparts, as Figure 13 shows.

Figure 13: Both EM investment-grade and high-yield corporates are offering an attractive level of additional income

Yield per unit of duration for EM versus developed markets investment-grade and high-yield bonds

v2_Opps in EMD_1296pxW_Fig 13

Source: Schroders, LSEG Datastream, ICE Data Indices; JP Morgan, as of February 29, 2024. Current performance trends provide no guarantee of future results and may not continue.

Conclusion: An opportunity investors may not want to overlook

The skepticism many investors may be having about emerging market debt is evident from the fact that the asset class saw significant outflows throughout 2023, and even after it started to rebound from the difficult year of 2022. Any investors who don’t own EM debt, however, would not have exposure to a quarter – 26% – of the world’s tradeable debt.3 Perhaps even more dramatically, emerging markets are now the prime drivers of the global economic engine. EM’s share of the world’s total economic output surpassed the developed markets’ more than 16 years ago, and the gap keeps widening. Today, EM’s share of global GDP is close to 60%.4

Clearly, these are not markets to avoid. Given all the appealing characteristics of this asset class, including the important structural changes that are occurring across these markets, investors may find it well worth their while to consider once again the return and diversification opportunities emerging market debt offers.

Resources:

1Source: Schroders research

2Source: “Leading countries in installed renewable energy capacity worldwide in 2022,” Statista

3Source: Schroders, BAML Research, Bloomberg, IMF, as of December 31, 2022

4Source: Schroders, BAML Research, Bloomberg, IMF, as of December 31, 2022

Authors

Autumn Graham
Credit Analyst, Emerging Market Corporates, Fixed Income Research

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