Emerging market debt investment views: resilience amid uncertainty
A combination of factors explains the resilience of emerging market debt amid recent market uncertainty.
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Emerging markets debt started the year on a positive note despite the extremely uncertain global trade and geopolitical environments created by recent President Trump announcements. Several EM local bonds and currencies rebounded from their oversold levels of last year while US dollar sovereign and corporate bonds continue to trade within their recent tight spread ranges.
This resilience of EM debt in the face of global uncertainties can be explained by a combination of positive fundamental, valuation and technical factors that can be summarised as follows:
- strong balance of payments exhibited by several emerging countries, which have led to a very low reliance on foreign funding;
- the upturn in global financial liquidity cycle that has gained traction judging by our measures of global monetary aggregates;
- credible monetary policy frameworks as tight monetary policies have been maintained, especially in Latin America where the level of real policy rates remain at historically high levels;
- appealing valuations that several EM local bonds and currencies are exhibiting again after their last year’s severe underperformance; and
- favourable technical conditions as global asset allocators remain severely underinvested in the asset class while market participants have become overwhelmingly long US dollar, which explains why recent President Trump import tariff threats have been absorbed reasonably well by EM currencies so far.
Our investment strategy turned more constructive at the turn of the year on US interest rate duration and on EM local rates and currencies. In contrast, we find less potential for spread tightening in EM dollar debt after the significant outperformance of last year. However, EM dollar debt still offers: (i) attractive income opportunities across the board; and (ii) appealing pockets of potential value that we still identify in sovereigns such as Argentina, Egypt, Nigeria, Ivory Coast, Ecuador and Sri Lanka.
The updated sectorial scorecard below provides a summary of our current strategy and the key changes (upgrades and downgrades) during the month of January.
We have not changed our long-held view that inflationary pressures are likely to remain entrenched with the distinct possibility that a second wave of inflation could materialise should the ongoing trade war turns into prolonged episodes of tit-for-tat tariffs.
However, we have recently identified the long end of the US treasury curve to be oversold and under-owned (chart 2). For this reason, we turned tactically constructive on US interest rate duration with the view that 30-year yields could drop to the bottom of the 4% to 4.9% range. This range is likely to remain in place until new evidence emergences regarding the medium-term direction of inflation and fiscal accounts.
In the meantime, we consider that adding to duration, especially when we recently reached and rejected the top of the yield range, was attractive from a risk reward standpoint.
This supportive technical outlook for US Treasury bonds is also beneficial for EM local rates, especially in markets which have cheapened substantially last year when a spike in bond yields occurred while inflation remained well-behaved. Mexican rates are a striking example of valuations at historical extremes, as the level of real rates shown in chart 3 has recently reached levels not seen since the late 1990s.
Despite the uncertainties related to US tariffs and some deterioration in Mexico’s fiscal and debt dynamics, this high level of rates is unwarranted in our view. Growth activity in Mexico is decelerating and inflation has recently resumed its declining trend after a brief and moderate uptick last year. The Mexican central bank is in now firmly in a position to resume its easing cycle possibly more aggressively this time.
We anticipate Mexican 10-year local bonds could rebound strongly from their current 10% yield levels. However, active hedging of the currency is still required as the ongoing trade and immigration frictions with the US could continue to be a source of exchange rate volatility.
It is also encouraging to see that Brazilian assets are rebounding this year after the fiscal woes experienced during the second half of last year, making Brazil one of the best performing markets so far this year. This stabilisation is justified in our view and the current rebound may have further to go for the following reasons:
- a significant washout in investor positioning occurred last year, which has left market participants extremely underweight or short the Brazilian real (chart 4);
- the interventions last December by the central bank helped to stabilise the Real, especially as the currency has become undervalued from a real effective exchange rate standpoint. Brazil’s trade balance is also still recording substantial surpluses despite some erosion in recent months.
- the resumption of aggressive rate hikes by the central bank notably in response to the deterioration in fiscal dynamics last year have reassured the markets about the credibility of the monetary policy framework;
- some improvements in the primary fiscal balance can be seen although these should result mostly from the end of exceptional government spending items (the so-called Precatorios spending) that are likely to reduce the primary deficit to a lower level of -0.6% of GDP in 2025.
Brazil and most other emerging economies have solid external accounts which should continue to provide credible buffers against the ongoing flare ups in global uncertainties. However, the fiscal dynamics have become a major source of concerns for several EM countries. There is a need for EM policymakers, especially in Brazil, to demonstrate a renewed commitment to long-term fiscal discipline.
We still believe that the situation is manageable in most cases given that:
(i) debt-to-GDP ratios have not exceeded unsustainable levels in EM ex-China (chart 5);
(ii) countries where debt ratios have surged in recent years (e.g. Brazil) have their government bonds offering a very attractive risk premium (chart 6);
(iii) growth has been resilient in most of these EM economies despite the monetary tightening of recent years, which reduces the risk of being caught in a debt trap; and
(iv) the debt is mostly denominated in local currency and owned predominantly by locals, which greatly helps to minimise refinancing risks.
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