EM debt “still primed to deliver alpha in 2024”

Emerging markets sovereign debt, as an asset class, is still set to deliver strong performance for 2024, says Polina Kurdyavko, head of emerging markets at RBC BlueBay Asset Management.

While emerging markets are intrinsically linked to overall global macro conditions, the direction of which remain difficult to predict, EM sovereign debt as an asset class is still primed to deliver strong performance – and therefore alpha – for 2024. This is particularly the case for those investors who are willing to be both nimble in their approach and long-term in their investment time horizon.

After a few rocky years, 2023 proved to be an exceptional year for EM debt, yielding double-digit gains across both sovereign credit and local debt. And while 2024 may hold some surprises in store, both in terms of monetary and fiscal policy dispersions and the volume of elections taking place across the globe, we believe the asset class offers numerous opportunities.

A golden opportunity
The first, and arguably most important, relates to improving fundamentals. Fuelled by a prolonged period of high commodity prices, particularly during the pandemic, many EMs have managed to reduce their fiscal and current account deficits. Meanwhile, global tourism has picked up, helping countries such as Turkey and the Caribbean to bring in additional revenue and taxes.

On top of that, EMs are displaying positive signs of growth, helping metrics like debt-to-GDP ratios to fall slightly. According to both our projections and of the IMF, EM countries will continue to see significantly higher-than-expected growth rates than advanced economies.

Concurrently, inflationary trends continue to show improvement across the EM universe (with certain exceptions). Unlike their counterparts, many EM central banks have been running a mostly orthodox set of monetary policies since 2020, raising their interest rates long before their counterparts in advanced economies. This puts them ahead of the curve, instead of lagging behind.

From the perspective of rating cycles, there were no sovereign defaults in 2023 and the risk of defaults remains concentrated in smaller countries. For these reasons, we believe the asset class is now past its default rate peak – a sentiment reflected by the strong investor appetite for those bonds already issued in 2024 and the subsequent rally in the market.

Even though forecasting total return can be a perilous proposition, we think investors should be comfortable with the fact that high carry offers the potential to offset quite a bit of volatility, should it transpire.

Against this backdrop, our view is that many distressed assets in EM are trading at a discount and should produce strong returns, especially with carry still close to 13-year highs.

According to our analysis, the probability of the asset class producing a positive total return on a one-year forward looking basis is quite strong. In nine scenarios of spread and 10-year Treasury levels, only three out of these 81 symmetrically simulated scenarios showed negative total return at the index level (assuming no further unexpected defaults, as is our base case for this asset class).

Therefore, even though forecasting total return can be a perilous proposition, we think investors should be comfortable with the fact that high carry offers the potential to offset quite a bit of volatility, should it transpire. This is a material difference compared to other core investment grade asset classes, which provide far lower levels of carry.

That said, the investment outlook somewhat hinges on the ultimate trajectory of US Treasuries, which are notoriously difficult to predict. We do, however, observe that US fixed mortgage rates are the highest they have been in the last 23 years, a period in which the US has experienced at least two pronounced recessions. The yield curve, too, appears to indicate economic softness through pronounced inversion.

A year of elections
With roughly half of the world’s population heading to the polls this year, there are several key elections that could impact both regional and global outlooks and, in turn, present significant geopolitical risk in EMs over the course of the year.

The most impactful will likely be the US presidential election when the return of Trump is looking increasingly probable. Indeed, history would suggest that a Trump presidency may very well inject further uncertainty and spike global market volatility, whether it be through tough rhetoric on China or agitating the world’s economic institutions. Yet despite the volatility ahead, EMs still present a compelling case for investors looking to add exposure to the asset class.

Clearly, there are exciting opportunities within EM sovereign debt for investors seeking diversification and growth potential. However, the political and economic challenges have not disappeared and so tapping into this asset class requires selectivity, in-depth knowledge, and extreme agility.

Investors would, therefore, do well to take an active approach, combining top-down macro analysis and bottom-up fundamental assessment, to enhance returns and reduce risk.

*Polina Kurdyavko is head of emerging markets at RBC BlueBay Asset Management.




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