331. Why the “stars are aligned” for emerging market debt

19 September 2024 (pre-recorded 11 September 2024)

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[INTRODUCTION]

Staci West (SW): Welcome back to the Investing on the go podcast brought to you by FundCalibre. This week we explore the opportunities and challenges within emerging market debt. Discover the current landscape of fixed income, the dislocation in sovereign debt spreads, and the role of local currencies and geopolitical shifts in shaping future returns.

Joss Murphy (JM): I’m Joss Murphy, today I’ve been joined by Polina Kurdyavko, manager of the BlueBay Emerging Market Unconstrained Bond fund. How are you, Polina?

Polina Kurdyavko (PK): I’m great Joss, thank you. How are you?

[INTERVIEW]

JM: I’m very well, thank you. Well, Polina, let’s kick things off. Why should investors consider adding emerging market (EM) debt to their portfolios?

PK: If I think about the EM fixed income landscape, we have a very interesting combination of the valuations against the fundamentals. On the valuation side, emerging market fixed income investors today in hard currency are getting yield on the index level close to high single digits, which is amongst the highest yield over the last two decades. And yet, if we think about hard currency default forecast, starting with sovereign debt, we would expect sovereign default rates to be zero this year and next after almost four years of high single digit defaults. This in itself is a very attractive combination on the corporate side. We expect defaults to remain below historical leverage of 3.5% going forward. So the corporate spreads and the corporate fundamentals look quite healthy, yet when it comes to valuations and the dislocation in spread, the biggest dislocation we’ve seen is in hard currency, sovereign debt, hence that’s where we see the best opportunity.

I would also say that when we look at emerging markets, local currency debt, the asset class that has been out of favour for a good part of the last decade given the devaluation of local currency it feels to us that over the last couple of years, the tide has been turning and there is a potential for outperformance of select local currency names as well, which after the US election could prove an interesting opportunity for investors.

The last point that I would mention is technicals. Despite the fact that the asset class has registered double digit returns last year and is in high single digit returns already year to date on the index level, we haven’t seen as an industry slows in the asset class over the last two and a half years. They’ve been outflows from the asset class. We feel that that’s likely to change. And actually, if anything, it gives investors a very clean technical backdrop combined with high valuations in a benign outlook for defaults overall, I would say one could say all the stars are aligned.

JM: You touched on it a bit there, but going more broadly, what is the outlook for emerging markets? Do you expect a weaker dollar and will this help?

PK: I think that when we look at the direction of dollar visiting local currency, we have to take a few things into account. Firstly, it’s the outcome growth in emerging markets despite quite focused monetary policy over the last few years, as you might know countries in emerging markets started hiking rates almost two years earlier than in developed markets, despite relatively tight fiscal backdrop because again, in emerging markets, unlike in developed world, countries have not widened substantially their fiscal deficits through covid and therefore maintained a better fiscal discipline. The biggest surprise over the last few years, when, when it comes to large emerging market economies has been on growth. And while the world and investors both in equity and debt mostly focused on slow down in Chinese growth, what they have missed is actually positive surprise in growth in large EM economies from Brazil to Mexico to Turkey, to South Africa to India.

The growth has surprised on the upside. By in large, it has been driven by a number of factors including higher commodity prices, given that two thirds of the countries at commodity exporters in some cases innovation, for example, in Brazil in particular digitalisation and innovation in the financial sector has helped growth in some cases growth of domestic investor base like in Mexico.

But also let’s not forget that geopolitical risk has not been announced right negative for emerging markets. In fact, if anything countries like Mexico have benefited from near shoring trend. Countries like India has benefited from low oil imports prices given the discounts they’re getting when they purchase their oil after the Russia/Ukraine war. So a number of countries have been beneficiaries or indirect beneficiaries of higher geopolitical tensions in the world. So to me, that outlook speaks quite constructive for the local currency performance.

On the other hand, if we look at dollar, it’s important to note that right now it’s a period of high uncertainty given we are yet not through the US elections, but once elections are out of the way, there is a narrative for potentially weaker dollar given the focus on some of the candidates on increasing growth, but also reducing inflation and increasing exports for which weaker dollar is more favourable. So the combination of those two factors could mean that going forward next year, we could see the continuous trend of strengthening local currency against weak years dollars, which we’ve started to observe couple of years ago.

JM: And Polina, just touching on a piece of news more recently does Elon Musk’s dispute with Brazilian Supreme Court matter? Bill Blackman said that a ban on the social media app X would make Brazil un-investible, is he right?

PK: In my opinion, it’s a little bit farfetched. Let’s face it. A number of big media companies and their owners have disputes with a number of countries, and just recently you’ve seen a headline of another media the owner which has a dispute with the European government. Now, if we look at this narrative, I feel that it’s quite common given the sector in which these companies operate. In case of Brazil, we feel that from what we understand, there was a breach of the legal framework, and that’s what the dispute is about. But we don’t see it as a game changer for Brazilian risk assets. If anything, we feel Brazil is probably one of the most mispriced assets in particular in local currency space.

JM: And can China recover and does EM need a strong China to work?

PK: You know, China recovery is an interesting topic because while the narrative for China slowdown has been quite widely spread, if you look at the Chinese exports data, it actually has been going stronger both in volume terms and in price terms. So if anything, when we talk about Chinese slowdown, it’s more a slowdown related to weaker domestic demand, not necessarily a slowdown of exports for that matter. And as a result we’ve seen other emerging market countries benefiting from this partially given the overall volume of exports, but also partially given the redirecting of those exports into some of the Asian economists on the back of the tariff hikes that has come through from the US and, and Europe. And therefore perhaps join back your attention to my earlier comments. If you look at the broader growth narrative in emerging markets, if anything, it has surprised market over the last couple of years on the upside, not the downside. So in, now, if you Chinese slowdown per se is not an impediment for growth in the rest of emerging markets as well as developed market economies.

JM: I know you’ve spoken about this a bit already, but just so we can be clear with our listeners, what are your preferred markets at the moment and are there any locally aimed currencies you are really excited about?

PK: Sure. On the hard currency side, as I mentioned, we prefer hard currency, sovereign hard currency, corporates here in the liquid market. And within that we like a barbell approach where on one hand we overweight high quality names in Latin America that export oriented, but have been penalised given the headline risks after the elections, for example, Mexico, and yet have potential for a reform on the oil and gas sector. That’s where we like taking risk.

On the other hand, we like a number of frontier markets, you know, having had double digit default rate in frontier markets. We are now back to the environment where we don’t expect default rates in frontier markets. And in some cases countries like Egypt have benefited from geopolitical support from their neighbours as well as the multinational institutions. We also like some of the assets that have recently gone through restructuring because in fixed income it’s very rare one can generate double digit consistent ROIs.

But after the countries have gone through restructuring, they usually have very high exit yields, 15% plus. And they also don’t have any debt to pay back over the next two, three years as they come from the restructuring supported by the AMF program. And here, you know, we like countries like Argentina countries even like Sri Lanka, Zambia, in other words, the issuers that have gone through very tough times but have come out of the restructuring successfully.

On the local currency, I would say that we favour Brazil, again, Brazilian the currency as well as rates. We feel that Brazil has a very interesting combination of a disconnect between very strong growth backdrop and very negative domestic sentiment, which is often a very healthy place to be as investor. And then we also like local currency frontier markets where we invest selectively. And perhaps I would also mention Egypt after the devaluation of the local currency presented an opportunity to generate 20% plus ROIs.

JM: How much value have you found by using shorts in the fund and could you give me an example of where it’s worked?

PK: That’s a great question because often investors in emerging markets are attracted to emerging markets returns, but worried about the volatility in emerging markets. And in EM Unconstrained Bond fund we try to focus on capturing as much upside as we can from the beater of the asset class and yet reducing the volatility in the asset class, which we’ve achieved over the last decade.

How do we do that? We do that by taking a different trading approach to different type of assets. In particular, we feel that EM effects is a great risk management tool. Yes, we can have a positive view on emerging market effects on individual country level. But also let’s not forget that the volatility in EM FX is substantially higher than the volatility in dollar denominated assets, which is why it can be a great hedge in terms of uncertainty.

And for us it’s by using MFX as a hedge that we’ve actually achieved much lower volatility on the fund than that over the beater of the asset class. At the moment. We have a number of short positions in particular on countries like Colombia or Colombian peso in effect because we feel that the currency is quite fairly valued and yet the direction of travel in local rates would warrant a weaker currency over the next one to two months. And therefore we feel that by having a short in Colombian peso, on one hand we’re expressing a negative fundamental review on the currency, but also it serves a very effective beta hedge for the portfolio. And we are also quite tactical in taking profits on our hedging and resetting them as we go through the market.

So the time horizon on FX exposure can be as short as one to two weeks and as long as three months, whereas the holding period in our hard currency exposure tends to be much longer and it’s between six to 18 months.

JM: Well, Polina, thank you very much for your time today.

PK: It’s an absolute pleasure. Thank you, Joss.

SW: A unique high-conviction fund which offers investors access to BlueBay’s best ideas across the Emerging Market debt universe. The fund is flexible and will invest in both hard and local currency debt and sovereign and corporate EM debt, depending on the best opportunities. As we heard in this interview, the fund can also short – or bet against – a sovereign, corporate or currency where it has a strong view. To learn more about the BlueBay Emerging Market Unconstrained Bond fund please visit fund calibre.com