A favourable starting point for emerging market debt?

After solid performance in 2023, the prospects for emerging market bonds remain promising amid a favourable macroeconomic backdrop and continued easing of monetary policy, which would support the asset class, according to Claudia Calich, M&G’s Head of Emerging Markets Debt. However, with ongoing uncertainty and the scope for election-induced volatility as billions of people around the world have the opportunity to vote, Claudia believes investors will need to be selective to find attractive opportunities. 

2023 proved to be an excellent year for emerging market (EM) bonds. Along with many other financial assets, they finished the year with a strong rally as the ‘higher for longer’ mantra quickly gave way to expectations of interest rate cuts from most developed market (DM) central banks by mid-2024. The gains in November and December provided the highest two-month combined returns of the JP Morgan EM government debt index since the global financial crisis.¹

“We believe there are several reasons to remain optimistic about the prospects of EM debt and currencies in the year ahead”
 

After last year’s stellar returns (EM government bonds in local and hard currencies rose 13% and 11%, respectively²), the opportunity in certain areas of the asset class, particularly within the high yield and distressed credits, has been dampened somewhat. However, we believe there are several reasons to remain optimistic about the prospects of EM debt and currencies in the year ahead, although we expect carry (coupon income) to play a larger role in 2024 than capital appreciation.

Favourable macroeconomic scenario

The resilience of economies amid higher rates surprised many investors last year. Looking ahead to 2024, our base case macroeconomic scenario is favourable as inflation has receded in most economies, central banks have been, or will soon look to be, easing monetary policy, and economic growth, while expected to slow down in places, may avert a recession. While a recession was widely anticipated at the start of 2023, by the end of the year there was a growing belief that major economies were heading for a ‘soft landing’, whereby inflation comes down without hurting economic activity. 

Having said that, this has pretty much been priced in by the markets, in our view, and ‘stickier’ inflation could lead central banks to cut rates far less than is currently anticipated (market pricing now points to over 100 basis points (bps) of cuts in the US)³. This would likely cause bond yields to move higher. (Bond yields and prices move in opposite directions). Alternatively, we believe it could lead to a deeper economic slowdown that could result in widening of spreads and lower equities, but a further rally in core sovereign bonds. (Spreads reflect the difference between the yield on EM bonds and equivalent US government bonds, or Treasuries).

Disinflation trend 

The EM universe remains one of the broadest and most diversified asset classes within fixed income, offering diversification by region, country, sector, currency and commodity. Today, it also exhibits a high level of disparity from an economic and monetary policy cycle perspective too. 

Over the past couple of years, EM central banks generally were very quick in increasing base rates in the face of high inflation. As a result inflation was broadly tamed allowing central banks to start their cutting cycles first, with Latin America leading the way in 2023. Brazil’s central bank cut rates four times at the end of last year and indicated further cuts lay ahead⁴. 

Conversely, Asia saw comparatively less inflation and therefore had more moderate monetary policies. In the EM space we are now at a point where, while we shouldn’t overlook short-term inflationary factors, the broader picture is one of disinflation. This could generally be seen as a favourable situation for the asset class: real (inflation-adjusted) incomes will rise as inflation slows and EM bond yields are likely to fall as policymakers ease rates. 

However, for 2024, we expect the disinflation to slow as the key drivers fail to assist to the level that they did in 2023. For example, energy and food prices are unlikely to help as much as they did last year with service inflation being stickier at current levels. With most markets pricing in rate cuts ranging from 100 to over 400 bps, we believe opportunities will be more selective and data dependent as opposed to the widespread bond rally we saw in 2023. 

Elevated yields

Yields in emerging markets, despite the 2023 year-end rally, remain elevated relative to their highs during the 2020 Covid sell-off; however, spread levels are not as historically high due to the movement in the underlying US Treasuries. But with room for further spread compression, we believe that EM debt offers upside potential in the near term, particularly with US rates forecast to fall to 3.6% by the end of 2025⁵. 

Within EM itself, there is also significant yield dispersion between investment grade (IG) and high yield (HY) names, particularly in the sovereign hard currency space, which creates potential opportunities for investors. While tail risks can’t be eliminated within an EM portfolio, diversification is important in managing potential drawdowns. 

A year for carry 

Looking more closely at the sovereign hard currency market, we believe the outsized 2023 returns of high yield and distressed credits (for example, bonds from Venezuela, El Salvador, Pakistan and Sri Lanka returned between 70%-150%) are unlikely to be repeated as bond prices have reached the 60-80 range. Similar future returns would bring those bonds near par (par value is the amount repaid by the borrower at the bond’s maturity date) – levels consistent with BB credits, which they are far from. In fact, there were 15 countries that posted total returns above 15% for the whole of last year. 

Conversely, there were just a handful of issuers that performed very poorly in 2023 (e.g. Bolivia and Ecuador), which limits the number of distressed credits that could return 50% or more in 2024. Therefore, we expect carry (the income received from coupons) to take a larger role in 2024 returns as opposed to price appreciation.

There is a wide divergence between the spreads of hard currency sovereign bonds. In our view, IG credits present limited opportunity for spread tightening, given that spreads are the lowest they have been in many years. 

In contrast, HY spreads are at very wide levels – they have only been higher at times of crisis such as the COVID-19 pandemic and the global financial crisis – and we see this as an area of potential opportunities. 

A supportive factor is that many of the single B and below-rated countries are trading now at single digit yields, meaning that they will once again have market access. Following a year where only one sovereign default occurred (Ethiopia), we are unlikely to see a significant increase in sovereign defaults from 2023 unless current economic circumstances change drastically.  

Opportunities in local currency bonds

Turning to the local currency market, we see plenty of attractive opportunities, even on a carry basis. For example, most local currency bonds underperformed the recent rally of US Treasuries. Mexican local currency government bonds (Bonos), which tend to be highly correlated with US yields given the close link between the two economies, not only yield more than 5% above comparable US Treasuries now, but they also have lower historical yield volatility given US Treasury volatility was very high over the past six months. 

In fact, it is quite remarkable that the 10-year US Treasury yield ended the year at 3.9%, almost exactly where it was at the beginning of the year, despite the very large moves we saw in the second half of the year⁶. 

With both countries facing elections in 2024, calling the US election and its subsequent policy stance is arguably harder than predicting the outcome of Mexico’s election.

Resilient corporate fundamentals

In terms of EM corporate debt, we believe that corporate fundamentals are in a good state. EM companies have much less debt than their DM counterparts across both the IG and HY segments. This resilience has arguably helped EM corporates, although expected defaults are ticking up, particularly for the most indebted issuers, which is what we would expect at this stage of the cycle. 

Notwithstanding this, corporate HY defaults are expected to end 2023 at around 3%, excluding those in Russia, Ukraine and China’s real estate sector. For 2024, defaults are forecast to be generally lower, according to JP Morgan, arguably reflecting the robust underlying fundamentals⁷. 

In terms of spreads, EM corporate debt currently trades tighter (with a lower spread) than government bonds. However, with the prospect of lower interest rates and a healthy macroeconomic background, we see a potential tailwind for the asset class.

Attractively valued currencies?

We remain selectively constructive on EM currencies, as we do not expect economic growth in the US to outperform that of EMs. Nor do we expect its monetary policy trajectory to tighten more, which would arguably lead to a stronger US dollar. Valuations are generally not expensive, in our view, with the exception of a few currencies such as the Mexican peso or the Czech koruna. 

Another point to note is that following outflows from the asset class in recent years, investors appear to be underinvested in EM local currency bonds, which faced stiff competition from high short-term rates in the US, UK and eurozone. This position could improve in future as DM central banks start easing policy and short-term rates decline. 

There is often a lag between positive asset price returns (as seen in 2023) and inflows – i.e. investors often chase returns, not anticipate them. Higher capital inflows would be supportive for EM currencies and/or for the accumulation of international reserves, which is positive for the creditworthiness of EM economies.

A year of elections

2024 has been described as one of the most important years ever for elections, with billions of people in 50 countries entitled to vote⁸. Bangladesh, Indonesia, and Taiwan have already been to the polls, but forthcoming noteworthy elections include South Africa, Mexico, India and, of course, the US and UK. 

Elections often produce volatility as investors can be nervous about political change. However, they can also create investment opportunities. Although elections tend to have negative connotations and potential downside risks, they can also have positive outcomes. In fact, recent elections in Turkey, Poland and Argentina all resulted in a subsequent rally in asset prices on the back of outcomes that led to improvements in economic policy making. 

Meanwhile, key geopolitical issues (Russia-Ukraine, the Middle East and China-Taiwan) remain unresolved, and the US presidential campaign is not helping to ease the uncertainty on this front, in our view. 

Cause for optimism?

Despite some uncertainty, we think the broader picture is still conducive to emerging markets performing well in 2024. Economies have been surprisingly resilient and have been largely able to adapt to the inflationary story and then the higher interest rate environment. 

With the Federal Reserve expected to cut rates in 2024, we have cause for optimism for emerging markets. This will especially be the case if the US dollar does not strengthen further, and risk aversion remains subdued. 

While the double-digit returns we saw in 2023 may not be replicated again in 2024, emerging market debt still offers compelling opportunities, in our view, especially for investors that are facing the reinvestment risk from short-dated bonds. Even if returns converge to their long-term average (mid-to-high single digits), we think that the asset class should not be overlooked.

¹ JP Morgan, 31 December 2023. 
² Bloomberg, 31 December 2023
³ Reuters, February, 2024.
⁴ Reuters, December 2023.
⁵ Forbes, December 2023.
⁶ Bloomberg, 31 December 2023.
⁷ JP Morgan, October 2023.
⁸ AP, “Over 50 countries will go to the polls in 2024. The year will test even the most robust democracies”, (apnews.com), 10 January 2024. 

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The scenarios presented are an estimate of future performance based on evidence from the past on how the value of this investment varies, and/or current market conditions and are not an exact indicator. The views expressed in this document should not be taken as a recommendation, advice or forecast.