EMD – good things come to those who wait
By Denise Simon (pictured), Lazard Asset Management – When it comes to investing in emerging market debt, patience is a virtue.
During the first quarter of 2020, the blended hard and local currency asset class suffered its worst quarterly loss on record with a loss of over 14 per cent amid the Covid-19 pandemic induced sell-off. Investors who stayed the course were rewarded handsomely with a return of over 20 per cent in the subsequent three quarters as it quickly became apparent that the market’s worst fears – a deep, prolonged recession and rising default rates – were far overblown.
The first quarter of 2021 was also a challenging environment for emerging markets debt, albeit to a much lesser extent than the prior year and for entirely different reasons. The asset class was caught in a tug-of-war between better global growth expectations and higher rates, with the latter winning the battle and the asset class falling over 5 per cent in the first quarter.
Importantly, we see good reasons for optimism and recommend investors stay the course or look to opportunistically add exposure to emerging markets debt.
First, interest rates are rising globally for the ‘right’ reasons – that is better growth expectations, rather than inflationary concerns. Growth expectations in the US have been ratcheted upwards several times this year thanks to multiple large doses of fiscal stimulus and a more successful vaccine rollout than many had expected. Meanwhile, the Fed has not lifted its foot off the gas pedal, indicating that “substantial further progress” is needed before tapering its bond purchases of USD120 billion per month. This has created an environment of ‘US growth pre-eminence’ whereby the US growth rate is expected to exceed growth levels in Europe and the developing world.
While such conditions are typically challenging for the emerging markets complex, we expect US growth outperformance to be relatively short-lived. Vaccination rates in Europe are already beginning to converge with those in the US which should lead to a convergence in growth rates. Sadly, emerging markets significantly lag the developed world in vaccination rates and many countries such as India and parts of Latin America continue to struggle with containing the virus. This discrepancy is not unexpected given the scarcity of vaccines supplies globally, however, we believe it is only a matter of time before the developed world catches up. Our base case is that over 60 per cent of the population in emerging markets will achieve immunity by the end of the year.
While the global backdrop is always a key consideration in the outlook for emerging markets debt, bottom-up fundamentals must not be overlooked. The pandemic took a toll on emerging markets – both socially and economically. Sovereign debt-to-GDP ratios rose in 2020 and fiscal balances deteriorated. On a more positive note, balance sheets have stabilised on the back of improved growth expectations and access to capital thanks to a healthy new issue market, IMF lending programs and debt sustainability initiatives. For commodity exporters, improving terms of trade should serve as an additional tailwind. Brent crude and iron ore prices have reached multi-year highs while copper prices have surged to a record high amid strengthening global demand growth and green-energy spending plans.
This backdrop should provide a welcome respite and allow the emerging markets to resume the rally that took a pause during the first quarter. Nevertheless, we believe it is especially important for investors to be highly selective in this environment. We see compelling value in three areas in particular: high yield hard currency sovereign debt, shorter duration corporates and local currencies. High yield hard currency sovereigns offer attractive yields of 5-7 per cent yields and we see potential for capital appreciation through spread tightening.
Meanwhile, corporates are an attractive source of yield with a lower duration and stronger balance sheets than developed markets peers. The asset class showed its resilience in 2020 and the first quarter of 2021 and we expect this to continue to be the case going forward. The asset class has historically been overlooked and many investors are just beginning to take note of the attractive return and risk characteristics of emerging markets corporates.
Lastly, we are structurally positive on emerging markets currencies for several reasons. We believe the peak in the US dollar roughly one year ago marks the beginning of a secular decline in the greenback. First, the interest rate environment should be less of a headwind going forward. The Fed is extremely dovish and we believe the majority of the move in Treasury yields has passed. Concurrently, many emerging markets central banks ending their dovish stances and some, such as Brazil and Russia, have already begun to hike rates. The dollar remains expensive from a long-term valuation perspective and the US’s twin deficits pose a risk that has long been overlooked. Meanwhile, emerging markets currency valuations are near all-time lows. The missing ingredient for sustainable currency appreciation has been emerging markets growth outperformance relative to developed markets and we expect this could begin to materialise later in 2021 and into 2022.
In short, we believe investors that remain committed to emerging markets debt will once again be rewarded in the months ahead. However, being selective – among both the different segments of the market and individual countries – will be key to capturing attractive risk-adjusted returns.
Denise Simon is a managing director, portfolio manager and co-head of the emerging markets debt team at Lazard Asset Management
This is a financial promotion and is not intended to constitute investment advice. The Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. Any views expressed herein are subject to change.
Issued and approved in the United Kingdom by Lazard Asset Management Limited, 50 Stratton Street, London W1J 8LL. Incorporated in England and Wales, registered number 525667. Lazard Asset Management Limited is authorised and regulated by the Financial Conduct Authority.