EM Debt – Cover story
always going to be a factor given the power between the two markets.
The main influence has nevertheless been persistent inflation and what this would mean for future monetary policy tighten- ing, as well as recessionary fears in the US and Europe. Amongst the high levels of uncertainty, investment-grade emerging market debt returns year-to-date are above those recorded by high-yield issues: investors’ “flight to quality” says Nicholas Hardingham, director of emerging market debt at Franklin Templeton, “results in a stickier, more supportive investor base for higher-rated bonds”.
In this scenario on-going concerns about a global growth slow- down and tighter liquidity conditions have expedited another wave of outflows from emerging market debt and may limit the scope for fund flows into the asset class for the remainder of 2023.
Developed versus emerging Comparing the wider macro-economic outlook of developed and emerging markets makes interesting reading when con- sulting the IMF’s latest predictions. It says gross domestic product growth in advanced economies will slow to 1.3% in 2023 and pick up modestly to 1.4% in 2024. The outlook for emerging market economies is stronger over the same period, with a growth rate of 3.9% in 2023, followed by an increase to 4.2% in 2024. Greg Smith is also bullish. “2023 is set to have the strongest growth versus advanced economies for 13 years,” he says. Which could lead to the question: emerging market debt crisis – what crisis?
Emerging market securities attracted around $10.4bn (£8.1bn) in May, according to the IIF. Hardly the sign of a crisis, but... “While our data shows a positive picture overall, this is the fifth consecutive month of China debt outflows and only marginal China equity inflows,” says Jonathan Fortun, an economist at the organisation. Inevitably, the wider global macro-economic outlook plays its part. Fortun adds the IIF maintains a view of lower inflation in the coming months for the US and a controlled landing of the economy, which may benefit emerging market flows overall. “Emerging market local bond valuations have showed notable resilience this year, as slow growth and broad dollar weakness are driving returns,” he adds. “Sentiment toward emerging market local government debt has lost momentum, returns are sliding back into negative ter- ritory,” Fortun says. “Nevertheless, we see an important rota- tion out of China debt. May’s data shows an outflow of $7.2bn (£5.6bn) in China debt securities, making this the fifth consec- utive month of outflows.” Fortun adds that term premiums have tightened sharply across
Most emerging markets, especially those with investment-grade credit ratings, are in a much stronger position than they
were in previous decades. Greg Smith, M&G
emerging markets. “Yet as central banks shift their focus to growth from inflation, we see an opportunity for investors to take advantage of the context by receiving in the front end of local yield curves, which has benefited emerging market debt flows overall,” he says.
Good shape Fundamentally though, despite talk of a debt crisis, emerging markets remain in good shape with little deterioration in their creditworthiness, even as spreads widened significantly during the sell-off in 2022. In this context, Hardingham remains “particularly focused” on attractively valued securities from issuers with “solid underly- ing fundamentals” and enough of a “buffer to withstand a period of higher global rates and/or loss of market access.” He also sees “some compelling opportunities” within the local- currency universe, particularly where higher nominal yields compensate for potential foreign exchange volatility, as well as amongst those currencies that have a lower correlation to the broader market.
Smith offers an even more positive outlook. “Emerging mar- kets are the engine for global growth at the moment, while recession risks loom in the UK and USA.” But to take advantage of any opportunities, rigorous research is necessary. “Emerging markets are no longer a simplistic unidi- mensional thematic asset class,” Bisat says. “Indeed, the new emerging market paradigm requires numerous asset alloca- tion and bottoms-up security selection decisions.” Yet a debt crisis is something investors should not worry about in emerging markets.
Issue 125 | July-August 2023 | portfolio institutional | 19
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