While fund flows into emerging market debt have struggled due to global headwinds, investment performance has been quite resilient. Last year, emerging market hard currency indices and local currency indices delivered low double-digit returns.
This was amid an aggressive Federal Reserve hiking cycle, heightened US Treasury yield volatility, a disappointing post-Covid China reopening, looming geopolitical risks and two major wars.
The resilience of the asset class has been impressive, attributable to improving institutional strengths, a lengthening history of prudent macroeconomic policies and the hard-fought credibility of central banks, in particular in their disciplined response to inflation.
Companies operating in these emerging countries have benefitted from this structural framework, enabling them to successfully access the international capital markets while at the same time developing and strengthening their local funding sources.
If US rate volatility eases, we could see fund flows turn positive as investors rotate back into the asset class given the attractive yield and spread pick-up relative to developed market credits.
In addition, the technicals for the asset class remain supportive thanks to a significant reduction in new external bond issuance over the past few years, combined with a prominent level of tenders, buybacks and calls. This has led to a shrinking emerging market debt stock.
Globally, it appears likely that we will see a disinflation cycle continuing through 2024. Developed market central banks, including the US Federal Reserve, have removed their hiking bias and are expected to begin easing monetary policy from restrictive levels this year.
Many emerging market central banks, which had hiked rates earlier and more aggressively than their developed market counterparts, have already begun to ease. On balance, investors could expect more accommodative monetary policy to support economic growth and favour the growth differential between emerging and developed markets.
China, the world’s second largest economy, should continue to grow around 5% for 2024. If needed, Beijing appears ready to increase support to prevent a sharp domestic growth slowdown. Policy support is likely to include liquidity measures, proactive fiscal policy and monetary support.
A key trend that investors should be monitoring is market implications for the US election in November this year. Whoever wins, the next administration is expected to continue supporting US domestic growth. Geopolitical risks need to be carefully monitored as they are the most likely potential source of economic headwinds.
The dollar is anticipated to be somewhat rangebound over the near term, which is beneficial to the emerging market carry trade and dampens volatility in emerging market foreign exchange.
Over the medium term, broad dollar weakness is likely as the Fed begins a cutting cycle and global growth rebounds with support from China, while a deteriorating fiscal outlook in the US may deter dollar dominance.
A global recession, the US election cycle and an escalation of geopolitical conflicts are some of the key risks to emerging markets to monitor this year. However, even if these risks materialise, active managers can weather the storm through credit selection within chosen countries, regions and sectors.
Emerging market economies are certainly vulnerable to a global recession. However, within a shallow growth deceleration, the higher quality credits with high carry may benefit, as emerging market credit spreads may widen less than the compression in Treasury yields.
Emerging market debt faces a potential headwind of heightened political uncertainty related to US foreign policy. There could potentially be an increase of volatility leading up to the US presidential election as candidates campaign on a return to protectionist policies. However, in the recent past, divisive campaign rhetoric toward foreign countries has been more a starting point for bilateral negotiations.
Additionally, some countries stand to benefit from these policy shifts, in particular from near-shoring and friend-shoring as the US and EU move supply chains away from China.
While geopolitical risks are hard to quantify and trade, certain regions are better able to weather these risks. Latin America remains more insulated from conflicts within the Middle East, Europe and Asia. Indeed, commodity-linked economies, which tend to be low-cost producers, may benefit from higher commodity prices.
The asset class is a secular improving story that offers an immense opportunity to invest across different regions, countries, industries, currencies and ratings.
Opportunities lie within the emerging countries which have institutional strengths, supportive growth outlooks and increasing linkages to developed markets, such as those within Latin America, with favourable outlooks in both Mexico and Brazil. Latin America remains more insulated from geopolitical risks and stands to benefit from a near-shoring trend that is already beginning to boost foreign investment, particularly in the case of Mexico.
Emerging market corporates have evolved into an asset class of their own, with a market capitalisation that far exceeds that of emerging market sovereigns and the US high-yield bond market.
The fundamentals for emerging market corporates have remained quite resilient despite the macro uncertainties, thanks to overall conservative financial policies. Moreover, emerging market corporates offer an attractive spread pick-up relative to emerging market sovereigns and comparably rated developed market credits.
Within emerging market corporates, we tend to favour the sectors that are strategic, i.e. those sectors deemed necessary for the smooth functioning of their domicile countries. These sectors include banking, utilities, natural resources and transportation.
All said, the macro environment is largely favourable for emerging market debt with opportunities to invest in countries that have a strong domestic story and in corporate credits, which have strong to improving credit fundamentals and a dedicated local investor base.
Su Fei Koo is a portfolio manager at DoubleLine. The views expressed above should not be taken as investment advice.