The year 2023 is shaping up to be a more positive year for emerging market debt and Capital Group has cautiously increased allocations to several regions within the asset class.
After the annus horribilis that 2022 was for global bond markets, 2023 has started a little more positive as it seems a deep recession in the United States is likely to be avoided.
Especially in emerging market debt, opportunities are starting to rise, for example in sub-Saharan Africa where debt in some countries is priced at default levels, while in Latin America yields are at sufficiently high levels to compensate for the risk, according to Harry Phinney, Fixed Income Director at Capital Group.
Most of the worst case scenarios in the near and intermediate term appear to be on track to be avoided and certainly valuations are cheap enough that you do want to tiptoe a little bit into risk
“Overall, we have a cautiously constructive view. Most of the worst case scenarios in the near and intermediate term appear to be on track to be avoided and certainly valuations are cheap enough that you do want to tiptoe a little bit into risk,” Phinney says in an interview with [i3] Insights.
But Phinney also warns that there are still many uncertainties in the market, ranging from potential further rate hikes by the Federal Reserve in the United States to the risks stemming from the war in Ukraine.
“Balancing risk through diversification and owning some of the higher quality issuers in the space…, those things help us sleep a little bit better at night in what is still a very uncertain market environment,” he says.
Africa & Latin America: Opportunities Abound
Africa is probably not the first region institutional investors think of when investing in fixed income, but the valuations in some of these markets have fallen to such a degree that they are currently trading around the levels you might expect to achieve after a restructuring.
And although the risk of defaults has risen, there is no reason to assume all of these bonds will default and/or all default at the same time.
“We certainly acknowledge that there is a much higher probability of potential default and restructuring of debt in some of the sub-Saharan African economies, but the argument that we have now is that a lot of those bonds are pricing in this potential outcome, and, if anything, they are currently priced pretty close to if not even potentially a little bit below expected recovery values,” Phinney says.
“We’re looking at a handful of more troubled economies in the African complex, where again price levels for these bonds appear reasonably attractive,” he says.
We certainly acknowledge that there is a much higher probability of potential default and restructuring of debt in some of the sub-Saharan African economies, but the argument that we have now is that a lot of those bonds are pricing in this potential outcome, and, if anything, they are currently priced pretty close to if not even potentially a little bit below expected recovery values
Capital Group has been positive about the opportunities in Latin America for some time, largely on the back of central banks’ early recognition there that inflation was resettling at a structurally higher level.
“For pretty much the first time in recorded history, many of these emerging markets got ahead of their developed counterparts by recognising that inflation was not transitory and that it was likely going to be much stickier,” Phinney says.
The early recognition of structurally higher inflation led central banks in Latin America to raise rates aggressively to the point that their next moves are likely to be ones of rate cuts, rather than further increases, creating an attractive environment for bonds.
“You saw very aggressive rate hikes across Latin America. So when we looked at countries like Brazil or Mexico, rates were quite a bit higher [than in developed countries]
“In the case of Brazil, policy rates went from about two per cent in early 2021, all the way to close to 14 per cent at the end of last year. With such an aggressive approach, it is not surprising to see the fruits of the central bank labour here.
“Inflation has started to roll over, real rates, which have already looked attractive relative to the developed world, are increasingly more attractive as inflation begins to come down.
“And of course when you hiked rates to that degree that also gives a pretty long runway for these central banks to now cut rates if and when they need to, based on more sluggish or potentially negative economic growth,” he says.
China and Asia – Caution Required
Chinese debt has been a growing part of the emerging market debt universe since its inclusion in some of the largest emerging market debt indices in 2019. But as the Chinese government maintained its zero-COVID policy for most of the pandemic, economic activity was disrupted, with a flow on effect to much of the region.
But after the adjustment of the zero-COVID policy in China in December 2022, Phinney has become somewhat more constructive on the Asian region again.
“Our view there has shifted a little bit,” he says. “We had been underweight the Southeast Asian economies for a variety of reasons, including the relative value but also just the concerns around Chinese growth as they were obviously grappling with the outcome and the consequences of the zero COVID policy.
Part of the reason why [the Asian economies] weren't impacted as much [by inflation] is because they had subsidy programs in place. This effectively masked some of the inflationary pressures in the economy
“Now that the policy has been abandoned, we have a little bit more of a favourable view on some of the countries in the region that could see a tailwind from China reopening,” Phinney says.
Unlike Latin America, many of the Asian economies have not been leading the way in terms of central bank activity and have been lagging in the pace of rate hikes. Although on the face of it, these economies seemed to face less inflationary pressures, some of it was simply repressed by subsidies, Phinney says.
“Part of the reason why they weren’t impacted as much is because they had subsidy programs in place. This effectively masked some of the inflationary pressures in the economy,” Phinney says.
“Those programs have largely been tabled and so inflation has crept up a bit, and you’ve seen central banks react, in some cases incrementally but the bias definitely has been towards higher rates there.
The US Dollar
The opportunities in emerging market debt are not just subject to what takes place in the local economies, but flows in and out of these markets also tend to be subject to the state of the US economy and the strength of the US dollar.
A strong US dollar compounds losses in emerging market local currency debt for US dollar based investors and makes it harder to raise external financing for these economies.
The dollar has been in a strong position pretty much since the end of the global financial crisis, but there are now some indications that this bull run might be coming to an end, Phinney says.
“A cyclical decline of the dollar could be closer than it has been in any recent period of time,” he says. “Certainly, the dollar was overvalued and 2022 poured gasoline on the fire. Now we are at a place where, even with the near-term correction we’ve had, we still think the dollar is not yet near fair value.
“If the Fed pauses its rate hikes or cuts rates down the road, that could be the catalyst for a more sustained decline in the dollar.”
The asset class has always been a volatile one, but with the appropriate safeguards in place, emerging market debt is starting to look attractive again.
The combination of low valuations and higher yields gives some room to deal with market disruption.
“Valuations are cheap for a lot of these bonds, and we would argue that there is enough yield buffer to at least partially offset some potential near-term volatility. At current yield levels there is a reasonable case to be made that the asset class could see positive returns, potentially this year, and likely further out over the next 18-24 months,” Phinney says.
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