Despite the uninspiring performance of emerging markets (EM) debt in the second quarter, we expect a stronger second half of the year characterized by resilient economic growth, lower global rates, and improving global liquidity conditions.
Macro Forces Drive Performance
EM debt is driven by two predominant macro forces—global economic growth and global liquidity conditions—and we have a constructive near-term view of global economic dynamics and expect a gradual improvement in global liquidity conditions.
In terms of global economic dynamics, we believe the global economy should continue to expand close to potential growth levels. In our view, the U.S. economy should remain resilient despite early signs of deceleration, European economic conditions should continue to normalize, and Chinese government stimulus should continue to support economic activity.
In terms of global liquidity conditions, we expect the global disinflationary process to continue, albeit gradually, and see policy rate cuts in sight in developed economies. The gradual removal of monetary policy restrictions should, in our opinion, lead to lower global rates and improved liquidity conditions in the second half of the year.
We believe EM debt offers an attractive investment opportunity within the fixed-income space.
Meanwhile, in EMs more specifically, growth remains surprisingly strong. Commodity prices are supportive. Disinflation is creating opportunities for monetary policy easing, and some EM central banks have already started easing. We expect the growth differential of EMs to developed markets to accelerate to above 2% in the next few years, and this should be a driver of capital flows into EM economies.
At the same time, EM credit fundamentals remain resilient in most places. Strong multilateral organizations—including the International Monetary Fund (IMF), World Bank, and Regional Development Banks—and bilateral organizations have provided ample and affordable funding to countries facing difficulties to refinance in the marketplace.
All in all, we believe EM debt offers an attractive investment opportunity within the fixed-income space as valuations remain attractive, yield levels are above long-term averages, real interest rate differentials are high relative to developed markets, and currencies remain undervalued in many places.
That said, geopolitical tensions are concerning—in particular, potential military escalation in Ukraine (dragging NATO countries into the conflict) and tensions in the Middle East. We will also watch the U.S. presidential election closely.
Key Opportunities for EM Debt Investors
Broadly speaking, we believe there are several attractive opportunities for EM debt investors. First, we are seeking to lock in attractive real and nominal yields via exposure to long-duration securities. Second, we believe the global market environment will remain conducive to the outperformance of high-beta, high-yield credit. Third, we see scope for fundamental differentiation and prefer countries with easier access to multilateral and bilateral funding. And lastly, while the higher-for-longer rate environment is affecting corporate credit quality on the margin, many corporate issuers have extended maturities and have refinancing options.
A View of the Potential Opportunities: Overweight/Underweight
Below, we break down some of our largest active positions by beta bucket, which is how we allocate our risk budget.
High-Beta Bucket
In the high-beta bucket, our largest overweight positions are in Senegal, Egypt, and Zambia, and our largest underweight positions are in Kenya, Nigeria, and Mozambique.
Senegal (overweight): We believe Senegal will see a marked improvement in its credit metrics as its burgeoning oil sector develops. Meanwhile, political risks have diminished after the opposition won the presidential election—and while the opposition’s campaign was premised on populist claims, ministerial appointments under the incoming government suggest a continuation of economic reforms and prudent macroeconomic policies.
Egypt (overweight): We have a constructive view of valuations and believe short-term fundamentals should be supported by financial assistance from bilateral and multilateral donors and substantial foreign direct investment flows from regional investors.
Zambia (overweight): Following the restructuring and exchange into two performing bonds, one of which has triggers for a step-up in coupon payments, we believe Zambia is attractive. These triggers are likely to be reached in the coming years. Despite the current drought-related shock, our outlook on Zambia's fundamentals remains broadly positive. We anticipate further financial assistance to help mitigate the negative impact.
We believe the administration of Mexican President-elect Claudia Sheinbaum Pardo should support Pemex.
Kenya (underweight): Kenyan authorities want to reduce fiscal borrowing needs but face challenges in implementing measures to increase revenue. Given the current political climate, pursuing fiscal consolidation by raising taxes will be increasingly challenging: For example, recently, the president did not sign a finance bill that would introduce several tax measures due to widespread public protests. Further cuts in expenditures are also likely to prove difficult, casting doubt on the current macroeconomic plan under an IMF reform package.
Nigeria (underweight): Nigeria has tight valuations relative to peers and has shown slow progress on economic reforms, and there are only 18 months left for this regime to focus on implementation of reforms before its focus is likely to shift toward the next elections. We continue to await further issuance of Eurobonds by Nigeria, which may present a more attractive proposition to reduce our underweight.
Mozambique (underweight): We currently do not hold a position in Mozambique due to the relatively tight spread and the possibility of development delays in the liquefied natural gas sector. In addition, the upcoming presidential election in October 2024 suggests that fiscal policy is unlikely to tighten, potentially introducing political risks and uncertainty.
Medium-Beta Bucket
In the medium-beta bucket, our largest overweight positions are in Ivory Coast, Panama, and Mexico, and our largest underweight positions are in Bahrain, Costa Rica, and Jordan.
Ivory Coast (overweight): We believe Ivory Coast has favorable valuations relative to its peers. The country’s debt is also supported by strong fundamentals and support from development partners, including the IMF. Ivory Coast authorities will receive further funding from the IMF under the Resilience and Sustainability Facility in 2024. In our view, the peaceful political transition following Senegalese presidential elections will also bolster confidence in the political process in Ivory Coast as we head toward the elections next year.
Panama (overweight): We are optimistic that the new administration will attempt to tackle Panama’s fiscal and growth challenges but recognize that there is uncertainty in regard to implementation. Hence, we prefer a more convex position, and have a small overweight in the long end of the curve. We also believe valuations remain attractive despite the risk of a potential downgrade in the tail end of 2024.
India has relatively high economic growth, resilient credit conditions, and likely policy continuity.
Mexico (overweight): We reduced some of our risk in Pemex based on valuations, but our overall outlook is constructive, because we believe the administration of President-elect Claudia Sheinbaum Pardo should support Pemex, and this could lead to spread compression over time.
Bahrain (underweight): Our positioning is based on a combination of relatively weak fiscal reform efforts, deterioration in regional geopolitical risks, and tight valuations.
Costa Rica (underweight): Fundamentals remain strong, but we believe valuations are unattractive as spreads have compressed materially.
Jordan (underweight): Conflict in the Middle East is hurting Jordan’s economy via severely reduced tourism, which reduces Jordan’s potential creditworthiness. These challenges have been largely offset by stronger international support, but geopolitical risks remain elevated.
Low-Beta Bucket
In the low-beta bucket, our largest overweight positions are in India, Bermuda, and Paraguay, and our largest underweight positions are in Indonesia, Uruguay, and China
India (overweight): We have a neutral spread duration position in quasi-sovereign risk based on tight valuations but are overweight through selective corporate bond exposure. India has relatively high economic growth, resilient credit conditions, and likely policy continuity after its elections earlier this year, which saw Prime Minister Narendra Modi’s National Democratic Alliance retain a majority in parliament.
Bermuda (overweight): We prefer valuations and fundamentals in Bermuda to those of other low-beta sovereigns. Bermuda’s bonds have similar valuations to those of Peru and Chile, but we believe the country has a stronger fundamental trajectory with less institutional uncertainty.
Paraguay (overweight): We also prefer Paraguay’s valuations and fundamentals to those of other low-beta sovereigns. Although Paraguay has lagged year to date, we believe the country is on an improving fundamental trajectory and has attractive valuations for the low-beta bucket.
Indonesia (underweight): The country’s fundamental outlook became murkier after presidential elections in February, and there is risk of fiscal slippage should the new government increase spending. In addition, a slowdown in the windfall from commodity exports and a persistently strong U.S. dollar backdrop could weaken external positions. Overall, we find valuations unappealing.
Uruguay (underweight): In our view, valuations are poor. Credit fundamentals remain strong, but bond prices have compressed materially since the COVID-19 pandemic, and we believe this results in limited scope for additional spread tightening.
China (underweight): Spread valuations are tight and regulatory risks for Chinese state-owned entities are unpredictable. Domestic consumption is lackluster, while the property market recovery has been slow. Based on bottom-up analysis, we hold selective corporate bonds that we believe show some upside potential.
Marco Ruijer, CFA, partner, is a portfolio manager on William Blair’s emerging markets debt team.
