July 9, 2024 | Emerging Markets Debt
Portfolio Manager
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As fixed-income investors, we tend to focus on the negative. Rising geopolitical tensions and the direction of U.S. Treasurys, for example, have been particularly concerning of late. But in our opinion, emerging markets (EM) debt is still attractive due to an improvement in fundamentals and attractive yields—particularly in the frontier markets space, where the disconnect between actual and perceived risk is creating alpha-generating opportunities for active managers.
A soft landing in the United States (with gradual interest rate cuts) would support EM spreads and foreign exchange rates (FX). At the same time, the corresponding decline in U.S. Treasury yields would likely boost EM returns. But as that scenario has become less certain, EM fundamentals have driven EM returns. That has occurred over the past five quarters, and, we believe, is likely to continue over the next year, for several reasons.
First, we have seen favorable policy changes in an array of EM countries, including Ghana, Egypt, Montenegro, Pakistan, Serbia, Sri Lanka, Tunisia, Turkey, and Zambia. Egypt, for example, has undertaken significant currency devaluation to improve the competitiveness of its exports and attract foreign investment; successfully negotiated an increase in its International Monetary Fund (IMF) program, which now stands at $8 billion; increased investment in critical infrastructure projects to stimulate economic growth and create jobs; broadened the tax base and improved tax-collection efficiency to increase government revenue; and improved the efficiency of state-owned enterprises (SOEs) through privatization or better management practices.
Growth differentials between EMs and developed markets (DMs) are shifting in favor of EMs.
Second, growth differentials between EMs and developed markets (DMs) are shifting in favor of EMs. According to the IMF, EMs are projected to grow by 4.2% in 2024, compared to a modest 1.8% growth forecast for DMs. The robust growth in EMs is supported by strong domestic demand, favorable demographic trends, and significant structural reforms, while DMs face headwinds from aging populations and slowing productivity gains.
Third, EMs are bolstered by robust international reserves, providing them with strategic strength to manage economic fluctuations. For example, Egypt experienced a 30% currency depreciation, but this was followed by an increase in its IMF program to $8 billion and an additional $45 billion deal with the United Arab Emirates (UAE), which further bolstered its external reserves. Similarly, Nigeria has implemented significant economic reforms to strengthen its financial stability. Other countries, such as Pakistan and Sri Lanka, are seeking to reengage with the IMF to secure further programs and increase foreign support, enhancing their economic resilience.
Fourth, fiscal budget deficits in EMs are narrowing, indicating a positive trajectory for these countries. For instance, South Africa’s budget deficit is projected to decline from 9.9% of gross domestic product (GDP) in 2021 to 6.5% in 2024, driven by improved tax collection and better expenditure management. Countries such as Egypt, Kenya, and Zambia are seeking to maintain prudent fiscal policies under IMF-supported reform packages, which should allow for the emergence of primary surpluses and an associated decline in debt-to-GDP ratios.
These improving fundamentals are manifesting in emerging countries’ credit rating trajectories. In 2024, we have seen more rating upgrades than downgrades.
For example, India received a credit rating upgrade from S&P Global Ratings, reflecting its strong economic growth and fiscal improvements. Similarly, Brazil was upgraded by Moody’s due to its effective fiscal consolidation and economic resilience, and South Africa also saw its outlook revised to positive by Fitch, driven by improved economic policies and a better-than-expected fiscal performance.
Currently, the amount of outstanding bonds that have a positive ratings outlook vastly surpasses the amount of bonds with a negative ratings outlook.
Currently, the amount of outstanding bonds that have a positive ratings outlook vastly surpasses the amount of bonds with a negative ratings outlook.
On the back of these policy changes, emerging markets bonds have continued to pay high yields. The JP Morgan Emerging Market Bond Index Global Diversified (EMBIGD) has a yield of around 8% as of May 2024, which is similar to that of U.S. high yield (represented by the Bloomberg U.S High Yield Bond Index). But historically, EM debt has had much lower levels of volatility (in part, because it is 50% investment grade).
So, hard currency EM debt is still very attractive to us, but so is local currency EM debt (particular frontier markets debt)—a space where we believe there is significant value, but the embedded risk premium is excessive. This is mainly because we believe the perception of risk is far greater than the actual risk that is existing in these countries.
This is because, as I suggested earlier, fixed-income investors tend to focus on the negative. The Middle East, for example, is home to an emerging crisis, which could be of detriment to neighboring countries such as Egypt. But Egypt is a strategic partner to the West, and has received substantial support to maintain that role.
Frontier markets have little correlation to DM policy shifts, and therefore have been relatively insulated from the ebbs and flows of global risk appetites. Markets such as Ghana and Kenya are largely driven by the structure of the local economy and non-portfolio investment financial flows.
Frontier markets have benefited from commodity prices, because they are overwhelmingly commodity exporters.
Frontier markets have also benefited from commodity prices, because they are overwhelmingly commodity exporters. They have seen strong multilateral support, and on the back of that support, have made substantial domestic policy adjustments. Moreover, frontier markets FX valuations offer a significant buffer to potential risk events such as the meaningful devaluations that we have seen in Nigeria and Egypt over the past quarter.
Local election cycles have the potential to influence policy direction and market performance, but these idiosyncratic developments unlock alpha-generating opportunities. And certainly, potential changes in U.S. leadership could affect global security and risk appetite, influencing EM debt markets. However, EM fundamentals and policy-driven opportunities remain strong, providing a buffer against such uncertainties.
These examples highlight how frontier markets, with their unique economic drivers and lower correlations to DM policies, offer a distinct investment opportunity that can enhance portfolio diversification and provide stability amid global economic fluctuations.
Moreover, it is in times of heightened geopolitical tensions and economic uncertainty that we find frontier markets particularly appealing, because we believe the disconnect between actual and perceived risk allows us to unlock significant alpha-generating opportunities.
These meaningful reform stories and positive pivots, in my mind, will likely continue to support the performance of the high-yield component of our emerging markets debt universe, and frontier markets in particular.
Yvette Babb is a portfolio manager on William Blair’s emerging markets debt team.
The JP Morgan Emerging Market Bond Index Global Diversified (EMBIGD) is a widely recognized benchmark for measuring the performance of sovereign and quasi-sovereign debt instruments issued by emerging market countries. The Bloomberg U.S High Yield Bond Index measures the performance of U.S. dollar-denominated, high-yield corporate bonds.
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