Emerging market debt investment views – December 2024
In the first of a new monthly series, we discuss the outlook for emerging market debt, focusing on the aftermath of the US presidential election and increased scrutiny of Brazil’s fiscal position.
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Our investment views remain broadly unchanged despite the recent negative news headlines regarding the possible re-escalation of the global trade war in the aftermath of the US election and the renewed fiscal uncertainties in countries such as Brazil.
We take comfort in the fact that emerging market (EM) fixed income, especially the hard currency debt sub-sector, has shown remarkable resilience in the face of these uncertainties. As highlighted in our sectorial scorecard, our current strategy remains guided by the following themes:
While we remain cautious on overall portfolio duration, we have recently taken profits on US rates hedges as market participants have increased their short positions to historical extremes, which could make long-dated US Treasury bonds susceptible to a short squeeze (chart 2).
We still see some value in EM dollar debt despite this year’s significant tightening in spreads. However, this value is increasingly concentrated in specific high yielding sovereign and corporate names.
EM local rates cheapened substantially following this year’s deep correction, especially in Latin American local government bonds. However, we are neutral for now as we are still waiting for currencies to show more evidence of stabilisation before we can turn more unequivocally bullish on EM local rates across the board.
Global asset allocators remain also severely underinvested in EM fixed income, as the asset class continues to be out of favour judging by the recent evolution of fund flows. Chart 3 shows a reacceleration in outflows from both hard and local currency debt funds during the month of November.
This wave of outflows, which should probably be seen as a knee jerk reaction to the outcome of the US presidential election, has been absorbed remarkably well by the asset class given the resilience shown by EM debt performance. The US election has exacerbated investors’ concerns about the impact on EM of a possible reescalation of the global trade war. Uncertainties about Brazil’s fiscal sustainability have also impacted somewhat EM sentiment in recent weeks.
We reiterate our view that most EM economies, including Brazil to some extent, are well positioned to absorb these global and domestic uncertainties thanks to resilient economic activity, credible monetary policy frameworks, stable balance of payments and lower reliance on foreign funding. These are the key reasons why our country vulnerability models continue to highlight that the risk of an EM “sudden stop” remains low, including in countries such as Brazil and Mexico, where investors’ scrutiny has recently increased.
This constructive assessment is corroborated by the recent strong total returns achieved by EM dollar debt in the face of increasing global uncertainties. We believe that it is only a matter of time before EM local debt also starts to regain traction following its recent deep correction. Indeed, EM local debt appears to have become oversold with local rates valuations particularly appealing. However, this sub-sector seems to be currently held back by the weakness in some currencies, which are serving as the traditional shock absorber in several EM countries. Based on global investors’ positioning in EM local debt markets and the historically extreme low levels of foreign participation in these markets, the re-pricing experienced this year by this sub-sector appears to be in its very late stages.
The risks associated with Brazil’s fiscal dynamics should not be ignored, but these have already been largely reflected in the depressed local government debt valuations (chart 4) and in the short positioning built by investors in the Brazilian Real (chart 5).
These valuation and favourable technical anchors remain the key reason why small exposures to Brazil local debt remain warranted with the aim of turning more aggressively invested when current fiscal concerns start to abate. We reiterate our view that Brazil is currently reaching peak uncertainty and that the country is reasonably well equipped to muddle through thanks to a number of factors:
- a monetary policy that still provides a long-term credible anchor,
- resilient economic activity,
- healthy external accounts (notwithstanding some deterioration in the trade surplus),
- low reliance on foreign funding,
- a strong valuation support for local bonds (with 10-year government bonds yielding 13.8%)
- and a relatively cheap real effective exchange rate (figure 6).
Strong Brazilian growth, with its remarkable resilience to very high real rates of recent years, combined with current fiscal concerns, have impacted inflation expectations, which appear to be in a new upward trajectory. However, policy rates expectations have already adjusted accordingly. The 12 months implied rate on swaps has just reached 15% versus current already elevated level of overnight policy rate of 11.25% (chart 7).
While Brazil’s headline fiscal deficit has reached a worryingly high level of 9.5% of GDP, the deterioration is mostly due to recent extremely high levels of interest rates which have taken government interest payments to 7.5% of GDP.
As shown in chart 8, the primary fiscal balance appears to be following a less worrying trajectory and could even improve in the next few months as strong growth and higher inflation should provide some boost to government revenues. The end of some exceptional government spending items (the so-called Precatorios spending) should equally improve the primary deficit to a manageable level of -0.7% of GDP in 2025.
Brazil’s fiscal dynamics can be improved even more significantly when President Lula’s administration decides to focus more convincingly on sending positive and coherent policy signals to the markets to restore confidence and put the central bank in a position where it does not have to hike excessively.
It should also be noted that fiscal vulnerabilities could be contained given that the bulk of the government debt is local currency denominated and remains mostly in local investors’ hands, which significantly reduces the reliance on foreign financing.
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