EM Debt Shines Amid Global Uncertainty

Emerging markets (EM) debt performed well in the third quarter of 2024, as resilient economic conditions, declining inflation, and increasing prospects for monetary-policy easing continued to support investor sentiment for fixed-income assets—and broadly speaking, we anticipate a similarly favorable market environment for the rest of the year.

There are risks that could generate higher volatility. Geopolitical tensions (including potential military escalation in Ukraine and escalating tensions in the Middle East) are certainly concerning. We will also watch the U.S. presidential election closely and assess the potential implications of its outcome for the global economy. However, we do not believe these risks have the potential to derail our positive outlook for the asset class.

More specifically, we see particular value in high-beta, high-yield credit and are still positioned for high-yield/investment-grade spread compression. We also prefer countries with easier access to multilateral and bilateral funding. Lastly, we believe there are opportunities in the corporate credit universe, which we believe offers resilient fundamentals, a low default outlook, favorable supply dynamics from ongoing negative net-financing needs, and a positive spread over sovereign, particularly in the front end of the curve.

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, Pakistan, and El Salvador, while our largest underweight positions are in Nigeria, Mozambique, and Rwanda.

Senegal (overweight): We believe Senegal will see a marked improvement in its credit metrics in the coming years as its burgeoning oil sector develops. While the parliamentary elections have introduced some near-term political uncertainty, they present an opportunity for the new president to cement his power and implement his reform agenda with a parliamentary majority.

Pakistan (overweight): Macroeconomic conditions have improved, and policy rate cuts are likely to reduce the country’s debt-servicing costs. The International Monetary Fund (IMF) has also approved a new $7 billion Extended Fund Facility for Pakistan, paving the way for reforms.

El Salvador (overweight): The fiscal outlook has improved, and we see an increased probability of assistance from the IMF. However, we are closely monitoring the situation. Although the Nayib Bukele administration is signaling increased fiscal austerity, we believe the biggest stumbling block to an IMF deal is the country's use of bitcoin as legal tender, which the IMF objects to.

We believe the biggest stumbling block to an El Salvador IMF deal is the country's use of bitcoin as legal tender.

Nigeria (underweight): We maintain our underweight position due to tight valuations compared to the country’s peers and the potential for increased supply. While progress has been made on reforms—including local oil production and cost-reflective fuel pricing—we expect Nigeria’s structural challenges to be addressed gradually. We are also awaiting further Eurobond issuance, which could present a more attractive opportunity to reduce our underweight.

Mozambique (underweight): We do not hold a position given relatively tight spreads and potential delays in the construction of liquefied natural gas facilities. The October 2024 presidential election also presents political uncertainty.

Rwanda (underweight): We do not hold a position due to tight valuations and fundamental concerns about Rwanda’s twin deficits.

Medium-Beta Bucket

In the medium-beta bucket, our largest overweight positions are in Ivory Coast, Panama, and Benin, while our largest underweight positions are in the Dominican Republic, Bahrain, and Costa Rica.

Ivory Coast (overweight): We believe the country has improving fundamentals and attractive valuations compared to its peers. Ivory Coast continues to show robust economic growth, with tax policy and administrative measures supporting fiscal consolidation, which may help mitigate moderate debt-distress risks.

Panama (overweight): We are optimistic that the new administration will address fiscal and growth challenges but recognize uncertainty regarding implementation, and believe valuations remain attractive despite a potential downgrade risk later in 2024.

Benin (overweight): Valuations are attractive and technicals are strong, in our opinion. Economic fundamentals are bolstered by growth dynamics and strong fiscal performance, driven by revenue collections. Moreover, the IMF supports the government’s reform agenda.

Qatar remains the most resilient in the region to falling oil prices due to its low fiscal breakeven.

Dominican Republic (underweight): Valuations are unappealing in our view, despite a positive fundamental trajectory.

Bahrain (underweight): We see regional geopolitical risks, weak fiscal-reform efforts, lower oil prices, and tight valuations.

Costa Rica (underweight): Despite strong fundamentals we believe, valuations are unattractive as spreads have compressed materially.

Low-Beta Bucket

In the low-beta bucket, our largest overweight positions are in Qatar, Bermuda, and Trinidad and Tobago, and our largest underweight positions are in Indonesia, Uruguay, and China.

Qatar (overweight): While Qatar spreads widened slightly from low levels over the quarter, bond prices rose due to high sensitivity to falling U.S. Treasury yields. Fundamentally, Qatar remains the most resilient in the region to falling oil prices due to its low fiscal breakeven.

Bermuda (overweight): We prefer Bermuda's valuations and fundamentals to other low-beta sovereigns. Bermuda’s bonds have valuations similar to those of Peru and Chile but exhibit a stronger fundamental trajectory with less institutional uncertainty.

Trinidad and Tobago (overweight): We recently moved to an overweight position due to more attractive valuations relative to other low-beta peers.

Tight valuations and unpredictable regulatory risks for state-owned entities sustain our underweight position in China.

Indonesia (underweight): Unappealing valuations persist in our view. The country’s outlook became murkier following the February presidential elections, with potential fiscal slippage as the new administration shifts focus to economic growth. Despite these risks, we hold diverse corporate positions based on resilient fundamentals.

Uruguay (underweight): From our perspective, valuations are poor. While credit fundamentals remain strong, bond prices have compressed since the COVID-19 pandemic, limiting the scope for spread tightening.

China (underweight): Tight valuations and unpredictable regulatory risks for state-owned entities sustain our underweight position. Recent monetary easing and anticipated fiscal stimulus may boost domestic demand and the struggling property sector. We hold selective corporate bonds based on bottom-up analysis, with attractive spreads over sovereign bonds.

Marco Ruijer, CFA, partner, is a portfolio manager on William Blair’s emerging markets debt team.