Hello, and welcome to unlocking markets the new RBC podcast. This is the place where we will be looking to bring you experts across the firm, providing opinions on markets global policy, sustainability, and macroeconomics, and how these feed into our investment decisions. I am Mike Reed Head of Global Financial Institutions. And today I'm going to be talking to Polina Kurdyavko, Senior Portfolio Manager and our Head of Emerging Markets.

We're going to be talking about a range of topics that we believe all investors should be thinking about right now. We will be covering emerging markets outperformance against developed market peers, geopolitics, the dollar supremacy, the difficulties of implementing ESG and emerging markets and so much more. Welcome Polina. We have a lot to get through today, so shall we just dive in?

Hi, Mike. With pleasure.

Emerging markets fixed income benchmarks, as I mentioned, have delivered positive returns this year, and have generally outperformed the developed market peers. What in your opinions have been the reasons behind this? And do you expect this to continue?

I believe that there have been two main tailwinds that helped emerging markets outperform the developed market fixed income indices. Those tailwinds have been with us for the good part of the last two years and are still present, namely, an orthodox monetary policy, which translated into numerous hikes across emerging markets with central banks taking a more hawkish stance. And acting well before developed markets central banks, as well as commodity prices that have helped emerging markets when it comes to the current account dynamic.

As a result, we've seen emerging markets outperform many developed markets through the course of this year. And we do think that this is set to continue, however, the drivers of outperformance might be slightly different. And we do think that the orthodoxy of the monetary policy is still firmly in place. However, we do feel that the commodity price dynamic might be a bit more volatile going forward compared to what we witnessed over the last couple of years. With that said, if I think about the environment that we're in today and the drivers of performance between now and year end, I do think a big part of those drivers would be more distressed stories that have gone through credit restructuring and are now delivering outsized returns when it comes to fixed income. With CCC and lower rated securities delivering over 25% return year to date, we would expect that outperformance to continue between now and year end.

Thank you so much. Well, we can't really talk too much about emerging markets without venturing into geopolitics. These have historically had a significant impact on emerging markets. And with the ongoing war in Ukraine, instability in Russia and rising tensions in the South Pacific. What would you say are the main risks and opportunities at this juncture?

I think that starting with risks, we have to focus on China. I do believe that looking at the relationship between US and China, the trend is unfortunately quite clear i.e., this relationship is more likely to deteriorate than improve over the medium to long term. With that said, we feel that the inter-linkages between the economies are quite high, and therefore, we're unlikely to see blanket Russia style sanctions imposed in China. Now, what is the silver lining for the rest of emerging markets? In our view, the silver lining is the fact that when this relationship continues to deteriorate the US needs as many allies globally as they can have. And that's where larger more established emerging market countries like Indonesia, like Brazil, like India, like Mexico are set to benefit. We do expect to see further trade deals being revised in favour of some of emerging market countries, like Chile, for example, we would expect US to be more tolerant on some of the monetary policy and fiscal policies and emerging markets, for example, Turkey, and we would expect, broadly speaking a number of emerging market countries to take advantage of this biggest geopolitical reshuffle that we have faced for the last 20 years.

Very interesting. We touched on economic policy at the start. But focusing specifically on inflation, it's very clear that this remains stubbornly high in Europe and the United States. And central banks there have been raising rates aggressively for at least the last 12 months. What is the situation in the major emerging market economies now?

Well, as I mentioned earlier, emerging markets have been early when it comes to rate hiking cycles, partially because they don't have the lender of last resort. And therefore, we've seen the majority of emerging market central banks starting to hike at least a year or, in some cases two years, before the Fed started hiking.

Now that orthodoxy has paid off, as we've seen inflation in most emerging market countries are starting to come down already from the middle of last year. And in some cases, inflation has reduced by more than 10%, for example Brazil back to single digits. We feel that this has created another tailwind for emerging market policymakers. And now with juncture where we would expect the central banks to start cutting rates supporting this move by prudent fiscal policy, which should help emerging markets cope better in the low growth environment.

Inflation interest rates very much feed into my next question here. And we've seen over a decade now of dollar supremacy, and emerging market local currencies have suffered. However, over the last nine months or so, we've seen a significant retracement in the dollar index is now the time for EM local currencies to have their time in the sun?

In fact, if we'll look at the performance of local currency markets, we have seen outperformance of local currency markets for the last 18 months visa vie the dollar denominated fixed income in emerging markets. And we would expect that to continue in absolute terms. However, I would mention that we would also expect the volatility regime to stay elevated in the local currency markets compared to hard currency markets. And in particular, I would stress that the volatility in the local currency market is less likely to be driven by inflation surprises, but more likely to be driven by headline risks, if you will bipolar governments and negative headlines both on fiscal as well as on the political side, which could translate into volatility of the local currency assets.

Coming on to something more sort of fundamental about emerging markets. Often they have been seen as a play on commodity markets. And as you said, some commodity markets the prices are coming off a little bit more recently. Do you feel it is still fair to say that emerging markets are a commodity play?

I think that when we look at the universe of over 70 countries, broadly speaking, two thirds of those countries are commodity exporters, so I think it's still fair to say that the exposure to commodities in emerging market countries is relatively high when it comes to its export focus. However, I would also mention that a lot of emerging market countries have used this surplus that have come from commodities in order to reinvest.

And if you will diversify the economy is making also the fiscal dynamic a lot less reliant on the volatility of commodity prices. I would also say that we are witnessing quite a significant transition in emerging markets away from, if you will, traditional commodities towards commodities that are more focused on renewable energy. And that is the move that requires a lot of funding. Hence, we have seen a lot of issuance in that space across the three regions in emerging markets.

Coming on to something more specific now, I'm aware, your investment team run a hedge fund, which operates solely in emerging market space. What would you say are the challenges and opportunities when running this type of hedge fund?

I think the opportunity presents itself through dislocation. It is a $23 trillion universe with over 2000 companies and close to 80 countries, it is a space which generally is not very well researched. And if we have the dedicated resources and spent majority of our time on the ground, in direct contact with those policymakers and company management, we do feel that we're in a strong position to generate returns from dislocation, which is exactly the environment we have witnessed for the good part of the last 10 years. The biggest challenge is in the name. When investors hear emerging markets, naturally, there is a home bias there's questions the question about the uncertainty and lack of clarity in some of emerging markets. And that's in our view has been the biggest impediment to raising funding in emerging market credit.

One thing I'd like to come on to now is ESG. And we really can't go too far these days without talking about it. It's been a huge theme in developed markets for several years now and is always on the agenda at any investment conference one attends. Is it really possible to implement a positive ESG strategy in emerging market fixed income? Were so many of the issues appear to fall short on E, S and G. Have you and your team addressed this? And can you highlight any examples of issues you may have worked with on this topic?

Thank you for the question, Mike. I think that it's a very complex and interesting topic. Firstly, I would dismiss the myth that in fixed income, it is difficult to influence the improvement in ESG risks, because generally speaking, is when the issuers need money the most, that they are most willing to listen to investors and follow their guidance. And emerging markets tends to be an area where the funding is always more challenging to raise than developed markets. Secondly, I would say that when we look at engagement with the issuers, we feel that without engagement, we can't really influence or improve any of the ESG risks.

If we look at the universe, half of the universe in emerging markets are countries with high or very high ESG risks. And if we exclude that universe, we feel that we're not really contributing to the change, and improvement in these G risks more globally, so our approach is through engagement. We don't invest without direct engagement with the issuers. And we try to help in particular, on the disclosure side, to improve the broader ESG standing.

I guess, thinking about the recent engagements that we've had, I can cite the quasi-sovereign oil and gas company in Mexico where, again, we've had a quite a common situation in emerging markets where the company has not signed a UN Global Compact list. And as a result, was negatively rated by most ESG rating agencies, even though they were adhering to all the general principles in order of ESG risks in order to be the signatory for this particular paper. And we thankfully, were able to highlight this to the company and work with the board in order to change this status quo.

Another example would be on the sovereign site where, for example, just recently, we saw the Minister of Finance of Indonesia, a country which has majority of exports focused on coal, a country which is also acutely aware of the need to reduce the coal production and focus on renewable projects. And we've been working with the ministry to create a framework in order to provide funding for projects, which would be replacing coal with alternative renewable energy projects. I would say that, when thinking about ESG in emerging markets, it's important to remember that it's a path towards transition. I also think it's important to remember that not all risk, E, S and G are equally important in different countries and can be equally delivered on in terms of tangible outcomes. We really need to focus on what are the priorities for us as investors, what are the priorities for the country and the companies and see if we can work together to deliver a positive outcome.

Thanks. That's great. It's really interesting to hear how you're engaging with companies, and how you're trying to deliver on this strategy. Well, thank you very much Polina, that was a really interesting talk through emerging markets. Some very interesting facts for our listeners to take away. If you're enjoying the show, please like and subscribe on your podcast platform of choice. Good luck, and goodbye. Thank you very much. Thank you.