EMD’s viability amid profound global change

In December 2022, Schroders published a research paper entitled “Regime shift: investing into the new era,” written by Johanna Kyrklund, our Group Chief Investment Officer, and Azad Zangana, Senior European Economist. In this report, the authors argue that the world is experiencing a change in regime, i.e., a major global shift in market and policy behavior. We believe the investment strategies that investors relied upon since the end of the Global Financial Crisis (GFC) are less useful in this environment. Higher interest rates are the most tangible result of the many forces driving these changes, which include pandemic responses, geopolitical tensions, low unemployment and energy transitions. However, the aforementioned authors argue that there are other significant trends that investors must heed to earn returns.

The main pillars of these new and critical developments are listed below. In this Schroders EMD & Commodities Intelligence report, we examine the current status of emerging market debt (EMD) vis-à-vis these important trends:

1. Central banks will prioritize controlling inflation over fostering growth.
2. Governments will respond with more active fiscal policy.
3. The dynamics of this multi-polar world will challenge globalization.
4. Companies will respond to higher costs by investing in technology.
5. The response to climate change is accelerating.

Aside from a few countries that have either downplayed the threat of inflation (Turkey) or those whose central banks were initially behind the curve (Hungary), as a group, emerging market (EM) central bankers have done an admirable job in combating rising prices. This should enable EM economies to recover by achieving stable inflation and sustainable growth faster than developed market (DM) economies. Such conditions are extremely favorable for EMD strategies.

Because rate hiking cycles began in EMs in advance of DMs, many EM countries are now nearing the end of their rate hiking cycle; several could even begin cutting rates later in 2023, e.g., Brazil, Mexico and Indonesia. Historically, the most opportune time to buy fixed income securities is toward the end of a rate hiking cycle.

Since the height of the pandemic, EM countries have generally suffered lower magnitude spikes in inflation relative to DMs, in part because they were not previously running at full employment and had more spare capacity in their economies. Notable exceptions include Eastern Europe, which was ground zero for the European energy crisis. Therefore the demand destruction cycle in many EMs should be shorter, allowing them to return faster to pre-pandemic growth patterns. Additionally, the amount of excess liquidity in EM economies is considerably less than in DMs, further supporting the quicker reversion to pre-pandemic patterns that we anticipate. Nothing is guaranteed when it comes to tackling inflation, of course, but it’s clear that EMs are in an enviable position and their central banks now have a relatively long track record of orthodoxy in monetary policy.

Figure 1 compares the current 12-month forward implied 10-year real yield versus each country’s own history (2002-2023) to arrive at a percentile ranking of real yields in select EMs. These large EM countries are all currently projecting real yields that are near their historic highs, suggesting a good entry point. With real rates in EMs that are well above those of DMs, EMD is well-positioned to receive the marginal investment dollar. A weakening US dollar could further support this trend.

Figure 1: Percentile ranked real 10-year yield (10-year yield minus 12-month forward consensus inflation forecast)

^{Source: Bloomberg as of March 2023, for the period of January 2002 through March 2023. Based on past performance, which provides no guarantee of future results.}

Governments will respond with more active fiscal policy

Due to the financial “scarring” that occurred as a result of the massive fiscal transfer payments to households and companies during the Covid-19 pandemic, DM governments need to meaningfully raise revenue or reduce spending to pull their debt-to-GDP figures back down to palatable levels. Across the board, whether out of necessity or perhaps wagering that their younger populations were less susceptible to the worst effects of Covid-19, the rise in government expenditures in EMs was not nearly as aggressive. Notable exceptions to the relative fiscal prudence of many EMs include Brazil, which overextended its finances in the runup to an election, and China, which clung to its Zero Covid policy until only recently.

DMs must confront the facts that they are no longer operating in an environment with zero interest rates and the costs to service their significant amounts of debt are now dramatically higher. The higher taxes required in DMs to ease their debt burdens should lead to economies that are both less productive and less competitive. Should EMs continue with their trend of relative fiscal responsibility, the dynamism edge should revert to EM countries.

Figure 2 illustrates that the cumulative forecast of interest-to-revenue growth is far lower for EMs over the next few years. The rate of change for EMs is also far lower.

Figure 2: Cumulative forecast of interest-to-revenue growth for DMs and EMs (2021-2027)

^{Source: IMF, includes forecasted data 2023-2027. Forecast may not be realized.}

The dynamics of this multi-polar world will challenge globalization

Even before the onset of Covid-19 drove supply chain interruptions, tense geopolitics were forcing companies to reconsider their supplier relationships. In the wake of Covid-19, multiple countries promulgated laws either offering incentives for domestic companies to repatriate their manufacturing (Japan) or requiring the production of sensitive goods to move closer to home (US). This trend is likely to make inflationary pressures more persistent in DMs due to higher input costs and less spare capacity.

The exact nature of this trend is likely to evolve. We don’t expect to witness a full withdrawal from China given its significant existing infrastructure and manufacturing hubs, not to mention the fact that maintaining current arrangements in China helps to secure the commercial promise of selling into that market. Rather, this could be initially focused on new capacity being built out. Regardless, nearshoring and onshoring are becoming increasingly popular, especially in sectors critical to national security. Consider that Taiwan produces 92% of last generation semiconductors within the technology and defense sectors, leaving the US vulnerable to a further deterioration in China-Taiwan relations.¹ This reality was a major impetus for the US to pass the CHIPS and Science Act, which provides significant incentives for both foreign and domestic chip manufacturers to set up sophisticated manufacturing facilities within the U.S.

We believe EMs are well-positioned to take full advantage of these deglobalization trends. Some of the evidence we see is clear across multiple regions:

• Globally: History has shown that a changing world order leads to geopolitical dislocations and supply chain disruptions, which we have already started to experience. These dislocations tend to reinforce bull cycles in commodities. Many EM commodity exporting nations stand to benefit from these favorable commodity cycles with regard to growth, balance of payments and capital inflows.
• Mexico: Employment in electronics manufacturing is on the rise, having increased 32.5% over just the last five years.²
• Indonesia: It is transitioning from simply a raw material supplier to a sophisticated manufacturing hub and turning into a foreign direct investment (FDI) powerhouse.
• India: This country has seen a huge leap in the World Bank’s Ease of Doing Business ranking in the past several years, from 142nd to 63rd, and it is committed to challenging rival China, which places 32nd in the same ranking.
• Poland and Hungary: They share the benefits of close proximity to industrial giant Germany as well as educated workforces and lower costs to set up manufacturing.
• US: Economists expect around 2.4M US manufacturing jobs to remain unfilled through 2028.³ A dearth of workers may force the US to rely on its emerging trade partners to fill its gap.

Figure 3 shows that eight of the top 15 net FDI destinations in 2021 were EMs. EMs also captured the top six spots on this list.

Figure 3: Top 15 net FDI destinations in 2021 (in USD Millions)

^{Source: OECD; net FDI calculated as FDI inflows minus FDI outflows. Shown for illustrative purposes only and should not be interpreted as investment guidance.}

Companies will respond to higher costs by investing in technology

Even if the current spikes in inflation diminish, it’s likely we will be operating in an environment with an overall level of inflation that is higher than what we took for granted following the GFC. With elevated unit labor costs, many companies will pursue further investments in technology to blunt the loss of productivity. Any lingering notion that EMs compete solely on a global basis through low unit labor costs is antiquated, in our view. On the contrary:

• EMs offer superb access to vast swaths of the new economy. Corporate issuers in EMs include global powerhouses in sectors as diverse as e-commerce, electronic vehicles, artificial intelligence, protein and food exports, and green energy.
• EMs account for more than 85% of global solar panel manufacturing capacity.⁴
• Asia accounted for more than two thirds of all patent, trademark and industrial design applications in 2021.⁵
• New economy sectors such as tech, telecom and consumer platforms made up more than 50% of the MSCI-EM Index as of 2020.
• Nearly 90% of people under 30 now live in developing economies. This cohort can adopt technology quickly, a competitive advantage for EMs.⁶

The response to climate change is accelerating

Certainly EMs straddle both sides of the sustainability challenge. On one hand, there is a high percentage of unfettered raw material and fossil fuel production emanating from EMs. On the other hand, many of these raw materials will be used to drive the energy transition around the globe. While EM sovereigns are already deciding on their respective paths to net zero and are unlikely to be swayed by individual asset manager pressure, EM corporates are listening with greater intensity these days.

It is clear that EMs will be the dominant supplier of the raw materials needed to drive the global energy transition and reduce the world’s carbon footprint. For example, China controls 55% of rare earth mining capacity and 75% of cell fabrication for advanced batteries.⁷

EM sovereigns are increasingly active in driving the energy transition. Chile is an aggressive sovereign in its energy transition, having pledged to reach net zero in carbon emissions by 2050, although it plans to ban the sales of internal combustion vehicles by 2035.⁸ Strong governmental action can spur the private sector. There is growing issuance of sustainability-linked bonds in EMs that either target low-carbon energy and agricultural production or desirable social goals such as minority representation in the workforce and management. If a company does not meet its quantifiable goals, it must pay a higher coupon rate on borrowings, aligning the interests of all.

Tracking such progress can be somewhat opaque. We have found sustainability reporting in EMs is a decidedly mixed bag. In North Asia (South Korea, Taiwan and China to a degree), we have found environmental, social, governance reporting to the depth and quality of reporting that world class companies produce. In smaller countries with more domestically focused industries and companies, the reporting tends to be less sophisticated. This provides an excellent opportunity for engagement by capable investment managers to help define best practices.

Finally, nearshoring efforts dovetail well with climate goals. By nearshoring operations, companies are able to reduce emissions in manufacturing and production. Additionally, shorter distances for transport also lower logistics emissions.

Summary

As we’ve shown in this report with relative ease, EMD lines up very well with the new regulatory and market regime that is upon us. Certainly, the onus is on the respective EM governments to help realize this opportunity through responsible economic management. Still, we feel the starting point for many EM countries is advantageous and could provide investors relative comfort when selecting investments that are positioned for this less familiar post-Covid economic and market environment.

^1,2,3,7 Barclays.

⁴International Energy Agency.

⁵ World Intellectual Property Organization Report.

⁶United Nations Conference on Trade and Development.

⁸Climate Action Tracker.