Investors, however, should not view emerging markets as a uniform group.
They span the spectrum in geography, development and degrees of resiliency. This creates a diversified opportunity set for portfolios. A judicious combination of emerging market exposures could drive attractive performance.
Sovereigns offering attractive yields
So, where can investors find value in emerging markets this year?
The best opportunity looks to be within emerging market hard currency sovereigns – government bonds issued by emerging market countries in stable currencies such as US dollars.
As emerging markets continue to normalise from their multi-year shock, their economies remain resilient, and financing needs will be manageable.
Based on current yields, emerging market hard currency sovereigns’ returns are already attractive.
Even a mild spread tightening could raise their total returns to double digits, while core developed market sovereign bonds yields are declining. Spread tightening refers to the reducing difference in yields between two bonds of the same maturity but different credit quality.
Against the backdrop of declining inflation, mild economic growth and the US Federal Reserve’s monetary policy easing, the spreads between higher-quality developed market investment-grade assets and riskier high-yield emerging market bonds will probably tighten.
Regionally, there are opportunities in central Europe, Latin America and Asia.
To avoid default risk, some countries – including Zambia, Ghana and Sri Lanka – are likely to embark on sovereign debt restructuring, a process in which the government changes the terms on loans to make them easier to pay back.
This could ultimately be positive for investors.
Other structural changes that positively affect segments of emerging markets include reducing supply chain reliance on China, and the prospect of increased foreign direct investment across other emerging markets.
There is value in emerging market corporate BB-rated and BBB-rated bonds in countries such as India and Mexico that are growing strongly and benefiting from this shift away from China.
Friend-shoring – a growing practice where supply chain networks are focused on political and economic allies – could also benefit countries already well connected to existing trade chains and will likely continue to attract investments from existing partners.
Value in foreign exchange
Within local rates, long rates in Latin America are attractive, while more mixed in Asia.
Disinflationary trends remain in many emerging markets, and real rates are positive.
Specifically, Brazil, Mexico and South Korea stand out, as Brazil is expected to cut rates below 9 per recent and Mexico should start cutting rates in the first half of this year. Caution is advised for South Africa, Hungary and Chile.
In emerging market foreign exchange (EMFX), one should not expect persistently strong US dollar performance given expectations of Fed rate cuts. Alpha opportunities exist in relative EMFX positions.
Many of the most preferable emerging markets currencies tend to be high carry, or are benefiting from relatively higher growth and flows.
In Latin America, the Brazilian real and Mexico peso look attractive.
In Asia, relative value positions favour Indian rupee and Philippine peso versus the New Taiwan dollar.
Investors should remain mindful of tail risks from global growth uncertainty and geopolitics – especially for countries where elections will take place this year, such as Mexico, India, South Africa and the US.
A barbell approach – investing in a mix of resilient investment-grade and higher-quality BB sovereign, quasi-sovereign and corporate bonds in the seven- to 10-year part of the curve – could drive better outcomes.
With the macro story of high inflation and escalating interest rates fading into the rearview mirror, this will be a year when an active investment strategy based on fundamental analysis and valuations of debt securities will be critical.
Last year’s returns in emerging markets debt more than held their own – the set-up for this year should attract investors back to the sector.
