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Emerging market debt

September 2021

Divergences open up EM opportunities

Rarely have emerging economies been subject to such powerful and conflicting forces. The result is a considerable dispersion in opportunities for investors.

01

Forces for change

Exceptionally powerful and competing economic forces are radically reshaping the landscape for emerging market (EM) investors. But for those with analytical capabilities, the resulting divergence in country and asset performance makes this fertile ground on which to generate returns.

The global macroeconomic environment is exceptionally uncertain. On the one hand, the Covid-19 pandemic keeps delivering ugly surprises; the exceptionally infectious Delta variant is the latest but unlikely to be the last. On the other, global central bank liquidity remains generous, as do fiscal stimulus measures. Inflationary pressures are growing – some are temporary, others could well take hold. Governments are under pressure to respond. Elsewhere, particularly China, there appear to be secular political shifts.

All of which further muddies an already complicated picture – there is huge variation among emerging market economies. Spanning the full spectrum of economic activity, from raw commodities to finished high end manufactured goods, emerging nations are expanding at varying speeds. At the same time, there’s significant differentiation in the assets on offer even within those countries. 

So, in some cases, when a country’s dollar-denominated bonds are richly-priced, it is its local currency bonds that offer the prospect of better attractive risk-adjusted returns.

At the same time, the growing popularity of green bonds among sovereign issuers adds a further dimension to an investor’s decision making. 

Varying impacts of Covid, varying amounts of stimulus, big divergences in country fundamentals, the introduction of green bonds on top of locally and hard currency-denominated securities all make navigating this EM bonds a challenge that demands expertise and experience. 

02

Covid

The single most important issue facing all countries, but particularly emerging economies given their relatively limited public sector and financial resources, is how hard they were hit by Covid-19 and how effective their responses have been. 

Countries’ relative performance, or their ‘pandemic trajectory’ is a key determinant of how their economies and markets are likely to shape up – and not just over the short term. There is also the longer-term threat from what economists call hysteresis, or the economic and social scars Covid leaves behind.

Fig. 1 - Vaccination matters

Covid-19 vaccination vs infection rates

Covid vaccination rates

Source: Johns Hopkins University, Bloomberg, Pictet Asset Management. Data as at 08.2021.

These effects will in part be determined by countries’ ability to contain the epidemic. That’s to say case, morbidity and mortality counts. These, in turn, will have been affected by the degree to which public health services have come under strain. These countries’ prospects will then be further influenced by the pace at which they are managing to vaccinate their populations (see Fig. 1). Countries that escaped the worst of the pandemic during 2020 and 2021 but have very low vaccination rates could still succumb to new strains of the virus, such as the Delta variant that swept through India during the spring and has since spread widely.
03

Commodities

With the recovery has come a boom in commodities, not least oil. Though generally prices have pulled back from their highs amid signs of a Chinese slowdown, the overall trend has been positive this year. Some of this strength has been a result of rising demand as life gets back to normal, partly stemming from bottlenecks in the supply chain caused by lingering after-effects of pandemic lockdowns. And emerging economies reacted differently to the revival in markets for raw goods.

Fig. 2 - Best in class

Current account vs real interest rates

Current accounts and real interest rates

Source: Pictet Asset Management, CEIC, Datastream, Bloomberg. Data as at 31.08.2021. 

Many commodity exporters were buoyed by improvements in their terms of trade. Markets welcomed the turnaround. Take South Africa – the country moved from running a current account deficit to a surplus as exports improved, which, in turn, boosted the rand. Elsewhere, however, an improving trade position was offset by other risks, such as political upheaval in the case of Peru and Colombia or geopolitical stresses (here South Africa is also at risk given febrile conditions in the streets). 

On the flip side, large commodity importers such as China, have been hit by higher raw material prices. This has had the effect of pushing up inflationary pressures, particularly in Central and Eastern Europe, or of weakening their current account positions, and thus raising external funding costs.

04

Social shifts

How emerging countries compare in terms of their performance on environmental, social and governance (ESG) matters is also bound to affect their investment appeal. Social and governance factors are particularly important in parts of Latin America, where leftist politics and populism are witnessing a resurgence. This raises the risk that these countries will suffer an erosion of their long-term creditworthiness as politicians attempt to spend their way out of problems, causing fiscal pressures to mount. At the same time, worsening youth unemployment, poverty and educational outcomes are a threat to countries’ human capital formation, with Latin America again particularly at risk. 
05

Monetary policy

Inflation is a big question for investors everywhere – but especially so in EM. Huge flows of global liquidity and substantial measures of fiscal policy have kick-started economies in the wake of the pandemic. Further waves of mass infection could yet prove a damper on both growth and price pressures. But as countries learn to cope with Covid, the existing stimulus could cause economic growth to boil over.

Fig. 3 - Inflating

Inflation rates vs target, %

Inflation rates vs target

Source: Pictet Asset Management, CEIC, Refinitiv. Data as at 31.08.2021.

So far, EM central banks have taken an aggressive approach as inflation breached their targets – by and large they’ve been well ahead of developed economies in tightening policy (see Fig. 3). As a result, we think the markets have more than fully priced in the degree to which rates will be hiked by the time they peak. For instance, we think too much has been priced in for Russia, Mexico and Colombia, presenting us with attractive opportunities in those markets. 

But even here there is considerable differentiation between emerging economies. For instance, inflation remains quiescent in emerging Asian economies so central banks there are likely to maintain dovish policies, especially in light of their rising infection numbers.

06

Making the most of differentiation

Investors in emerging markets have their work cut out. Countries face more complex challenges than ever, many of them brought to the fore by the Covid pandemic. It has compounded the impact of differing degrees of development and differing access to resources, be they natural or man-made and ranging from infrastructure to human capital to strength of institutions. And it has added another dimension to domestic politics 

Pictet Asset Management has a multi-faceted investment approach, using expertise from across the firm, that weighs up macro, political, environmental and social dimensions. 

Take our approach to investing in Chile. We see limited value in Chilean 10-year dollar-denominated debt, which trades at a spread of just 99 basis points over US Treasuries, and so have an underweight position in this asset versus the benchmark across our portfolios. Where we do own the hard currency bonds, we express a preference for the country’s green bonds that trade in line with the conventional bonds. For bonds priced in Chilean pesos, our recent bias is to receive local rates, as we believe that the bonds’ recent weakness implies expectations for too many policy rate hikes. At the same time, we have a more strategic bias to be overweight the currency, as a recent bout of weakness presents an attractive entry point. 

Investors in emerging markets have their work cut out.

As a team, we have learned to pay greater attention to the risks and opportunities presented by environmental matters and transition risk. 

We think green bonds are a good way for governments to finance climate change initiatives and consequently encouraged Hungary to start a green bond programme that we could participate in at the time of issuance. Romania has been less quick to adapt these measures, but here too we have been pushing the government to recognise demand for these instruments. Encouragingly, it has responded by developing a green bond framework which should help build its sustainability-focused credentials. 

We have a global reach, with a regional approach based around London, Singapore and New York, giving us local perspectives across the emerging market universe that we marry with our global macro and strategy strengths.