Talking Heads – Plainer sailing ahead for emerging market debt

Daniel Morris: Hello, and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing emerging market debt. I’m Daniel Morris, Chief Market Strategist, and I’m joined by Jean-Charles Sambor, Head of Emerging Market Debt. Welcome, JC, and thanks for joining me.

JC Sambor: Glad to be here. Thank you very much, Daniel.

DM: Emerging markets have been interesting, challenging and volatile this year and last year. In a lot of investors’ minds is not only China, but the contrasts between China and the rest of the world. For example, year-to-date returns for emerging market equities excluding China have not been too bad and China is clearly the outlier. Please tell us to what degree that’s the same in fixed income.

To start with fundamentals, how do emerging markets look in contrast to developed markets – are we seeing a decoupling? What’s happening in China? Do you think people are looking to a ‘new China’, and if so, will it be India?

JCS: Last year was a really difficult year for emerging markets – the perfect storm. There were some defaults, the war in Ukraine and all the China uncertainties. This year is much better. It’s not great from a macroeconomic standpoint, but if we’re talking about a hard or soft landing in the US, in Europe, in emerging market (EM), it’s about whether GDP growth is higher than or the same as last year.

We expect many emerging markets to grow reasonably well this year. We see inflation collapsing in many emerging markets, and these markets’ fiscal accounts and balance of payments are quite healthy. Most emerging market countries have been accumulating reserves and have healthy current account surpluses and fiscal deficits are fairly well contained.

Public debt levels are much lower, as there wasn’t the huge fiscal stimulus during Covid that we saw in developed markets (DM). That created some strong inflationary pressures in DM, which is not the case in emerging markets, where very few had massive fiscal stimuluses. Because of that, they are enjoying the benefit of low inflation, so overall, the macro picture looks much better than in developed markets.

DM: What if we compare and contrast China and India?

JCS: China is really the exception, with much weaker-than-expected growth. Even if it manages to reach 5% GDP growth this year, it’s not a great number.

Our view is that policymaking overall has been relatively disappointing, with only a piecemeal approach towards fiscal stimulus or supporting the property market. Most of the damage is now behind us and there will be more policy support – fiscal, monetary and direct support to the property market. The journey is likely to be smoother in the next couple of quarters.

As to what would be the ‘New China’? Well, China is to some extent ‘new China’, because we are likely to see a rebound. But there are other countries like India that are in much better shape than they were in the past. We see strong growth momentum and inflation is contained. If we expect lower commodity prices, India should benefit as it is a massive net commodities importer.

Some countries that struggled last year because of inefficient policies, like Turkey, are currently coming back with a strong rally because of the new policies implemented by the new team in place. So, we are seeing some improvement there.

We are also seeing some improvement in Latin America, especially in Brazil and to some extent in Argentina, although we are cautious on that front.

DM: If we look at some of the sub-asset classes within emerging market debt, what are the parts of the market that you like and where are you more cautious?

JCS: On the hard currency side, it was painful last year, with Treasuries selling off and having a negative impact on returns. On top of that, there was massive spread widening because adverse geopolitical events and the war in Ukraine.

This all seems to be stabilising now and our view is that with US Treasuries likely to stabilise, the spreads in many emerging markets are quite dislocated. We are likely to see some significant spread compression on high-yield bonds, so we are positive; this is perhaps less so on investment-grade. There the tightening has already happened.

On the hard currency side, we see potential for some outsized returns. Local currency this year is really a game changer after seven years. EM currencies weakened significantly against the US dollar and EM rates sold off because of inflation fears. Now we are at a turning point. We see inflation falling in many emerging markets. If you remember, EM central banks were the first to hike rates, especially in Latin America, well before the US Federal Reserve. Now they are the first to cut rates and they have a lot of room to do that this year and in 2024.

Since  we are close to the end of the US tightening cycle, the US dollar should weaken across the board and EM currencies should appreciate significantly. So, for the first time for a long while, we are positive on EM local currency bonds, the drivers being both EM local rates and EM foreign exchange.

DM: For success in emerging market debt investing, you’ve got to be conscious of the risks. What keeps you awake at night – credit default, geopolitics? What could go wrong?

JCS: I would say that everything that could go wrong already went wrong last year – it was the perfect storm: the Fed tightening cycle, the war in Ukraine, massive outflows from emerging markets and a weak macroeconomic situation.

It’s hard for me to see additional outflows because the money has left already. If inflation rebounds in the US and the Fed is much more hawkish than expected, that will be negative, but that’s not our scenario. The Fed being close to the end of its tightening cycle should be supportive of fixed income and specifically supportive for EM fixed income. China is a massive risk, but in my mind, this risk is already priced in, and we should see more of a policy response, which is long overdue.

We still see some risk of corporate credit events, but default rates in emerging Europe, the Middle East and Africa are likely to fall this year. There are likely to be a couple of credit events for specific culprits, but we don’t see sovereigns defaulting. We expect default rates to go down even on the EM corporate side; we should see an uptick in default rates in the US or Europe because of the weak economies.

The risks are priced in and to some extent have already materialised last year. While that may not sound too optimistic, we believe the technicals and the fundamentals favour emerging market debt.

DM: JC, thank you very much for joining me.

JCS: Thank you very much, Daniel.