What are the triggers that send you into panic mode? Mine tend to be driven by news of anticipated shortages – most likely stemming from my Soviet heritage. In 2020, when it was announced that Covid-19 was a pandemic, my instant reaction was to take a trip to the shops to stock up on provisions. Likewise, last November when a senior executive of a company in Beijing advised me to stock up on Christmas presents due to predicted shortages, my panic button went off again. With further inflation pressures looming and the US Federal Reserve embarking on a hiking cycle, emerging markets (EM) investors have also been in fear mode for the last twelve months, as evidenced by negative index returns across most EM assets.
Is this mode still justified looking at the year ahead?
Given the headwinds across EM, one would be forgiven for thinking such fear is warranted. Latin America has seen several leftist leaders coming to power, notably in Peru and Chile. This year’s election calendar looks equally precarious with Colombia and Brazil presidential elections potentially bringing a stronger leftist tilt to the region, which could unsettle markets. In Asia, zero-Covid policies continue to cause supply chain disruptions. The Chinese government’s policy solution for the real estate sector remains unclear, with most bonds in the sector still trading at distressed levels. In the CEEMEA region, the Russia/Ukraine conflict creates uncertainty in pricing assets in these countries as well as across broader risk assets, given potential implications for gas supply. Meanwhile, in Turkey, an unorthodox policy approach is bringing the country to the brink of a crisis. A number of countries like South Africa will continue to face growth challenges. That’s not to mention a few EM high-yield countries, such as Sri Lanka or Ethiopia, that could potentially face debt reprofiling this year.
Does this mean investors should steer away from EM for the next year? Absolutely not. In my opinion, this is precisely the time to be active in EM. Here’s why and how.
Conventional wisdom would say that EM local debt should underperform in a rising rates environment. However, there are a number of indications suggesting that a large part of the damage has already been done and that the flow dynamic, combined with fundamentals, could be supportive for the asset class. While the US is just starting its hiking cycle, most EM countries have been hiking rates for the better part of last year, with the market repricing the front-end curves of EM local rates by 300-400bps. Today, most EM local markets have projected positive real rates on a one-year forward-looking basis and reflect the highest historical real rate differential with developed markets (DM). This means that the cost of shorting EM FX has become prohibitively expensive. It ranges from 5-6% in the likes of Mexico, South Africa and Chile to a whopping 11% for Brazil. At the same time, current account dynamics remain supportive in the majority of EM countries that have local issuance.
What are the implications of the higher cost of funding on debt sustainability in EM?
Overall, the rising cost of debt doesn’t put debt sustainability in question per se, but it does put a higher emphasis on the policy mix. Over 90% of EM issuers are able to cope with higher US rates and deliver higher carry than DM credits without debt sustainability issues, based on our analysis. Those countries that do have debt sustainability concerns or unorthodox policy mix are already, on average, trading at 50–70 cents on the dollar, close to historical recovery rates. The high yield segment of the sovereign index is offering a yield close to 8.5%, or 650bps spread. This implies a default rate in the high single digits for EM high-yield sovereign debt, something that I believe is unlikely to materialise in our base case. Given the level of spreads, one’s breakeven point would imply yields rising to double-digit territory – a level that has only been reached twice in the last 20 years and that did not last for more than a few months.
On the corporate front, outside of Chinese real estate that trades below 50 cents on the dollar, the expected default rate remains in the low single digits. Most sectors either have high margins to withstand higher rates (e.g. telecoms); are investment-grade rated with longer maturity profiles and inflation-linked tariffs (utilities); are supported by high commodity prices (oil and gas, metal and mining) or outright benefit from rate hikes (financials).
What about flows?
In local markets, we may be seeing a stabilisation of some of the flow dynamics that have contributed to the underperformance of the asset class in prior years. Over the last few years, US equities captured the lion share of global flows, while the move to include China in several DM and EM indices created demand for CNY assets – to some degree at the expense of other EM local assets. Today, the US has a 0.25% policy rate and 7% inflation, with inflation risks pointing to the upside and growth risks to the downside. This could put more pressure on US equity flows, as witnessed by the NASDAQ’s 15% drawdown at the beginning of the year. These flows, in the absence of an EM-specific crisis, could find their way back into EM local debt. In hard currency, the flows are likely to be driven by expected default rates, breakeven yields (i.e. tailwinds) and the underlying volatility of the asset class.
So, when dissecting risks in EM countries and companies, it feels that while volatility is likely to remain high, there are at least as many tailwinds for the asset class as there are headwinds. If investors can be patient and look through the market volatility, they should be able to pick up attractively priced assets that are money good.
With that said, if one wants to take full advantage of the volatility and the return potential in the market, in my view absolute return strategies are the most suitable vehicles to capture this. Yes, EM hedge funds are back for the first time in ten years. They allow investors to take short positions in cash credit, as well as holding long views. They also can mitigate rate risks and duration concerns. Similarly, EM funds that focus on dislocated/illiquid loans – the latest addition to EM fixed income products – should also perform well in this environment. In this segment of the market, investors are paid double-digit returns as an illiquidity premium (as opposed to excess credit risk) while buying loans below par. It is worth noting that, because these loans are predominately issued as floating-rate instruments, they also offer protection against higher rates. Moreover, the lock-up nature of the vehicle protects investors against redemption risks – the strategies avoid being forced to crystallise mark-to-market losses or take duration bets.
Investors who aim for higher absolute returns should ideally be in a position to look through the entire credit spectrum and roll up their sleeves on recovery analysis for both corporate and sovereign debt. This requires deep experience and strong credit skills but, when approached correctly, investing in distressed assets can potentially provide outsized rewards for the level of risk undertaken. Looking at the hard currency EM universe alone, performing countries like Tunisia and El Salvador offer the potential for 30-40% returns on a one-year basis, not to mention Chinese real estate, where one can potentially double one’s money over the same time period. Doing the credit work can offer investors potential opportunities to earn double-digit returns in an asset class with inherent risk/reward asymmetry.
Investors’ pendulum tends to swing at a relatively fast pace between greed and fear. While there are no doubt challenges ahead, pressing the panic button now and sitting on the side-lines until the dust settles is likely to result in missing the opportunity. Indeed, it is usually when sentiment is cautious and investors can’t see the light at the end of the tunnel that the opportunity set in EM tends to be more attractive. The ‘fight or flight’ response is helpful when faced with a physical threat but going into panic mode when it comes to EM investing tends to yield higher transaction costs, not higher returns. As one seasoned investor once said, “In investing, what is comfortable is rarely profitable”.
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