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EM debt: What’s driving investor appetite?
Emerging markets (EM) expert Polina Kurdyavko explains why the current macro environment looks positive for long/short strategies, with signs of medium-term beta opportunities also on the horizon.
We anticipate the next 6–9 months are likely to provide a fruitful environment for hedge fund strategies that can take advantage of market volatility. There are several areas that we would point to from both a beta and a long/short perspective.
In terms of beta, yields on the asset class sit at a 13-year high. Even though there could be further downside in the short term, the medium-term value proposition in select parts of the asset class looks compelling, in our view.
Historically, investors have generated robust total returns by taking advantage of sell-offs in EM fixed income and we expect this period to be no exception.
We believe there are three preconditions that need to be met before the beta of the asset class is likely to turn more substantial:
- US rates: Although inflation remains persistent, the long end of the US Treasury curve is starting to price in a higher recession probability and therefore has become better anchored. High-carry assets such as EM are more dependent on the stability of the rates curve to perform, rather than a rally in the rates curve.
From this perspective, we may not be too far from seeing the longer-dated part of the curve becoming more stable. - Russia/Ukraine war: Investors are looking for some resolution to the war and the consequential impact on both energy and agricultural commodities. As long as the uncertainty continues, it will be difficult for some EM assets to stabilise. While this could create challenges on the beta side, it also creates an environment where the flexibility to express long and short positions can prove advantageous.
- Political volatility: A number of EM countries are simultaneously going through political transitions. In many cases, the result of the transitions would determine their levels of engagement with the IMF, for example in Sri Lanka, Tunisia and Pakistan, but also to some extent in Argentina. Our expectation is that in a number of these cases, the outcome may be positive on the margin.
Nevertheless, as the stories play out, we believe having flexibility and the ability to be nimble will be paramount for delivering positive returns.
Regarding long/short trade structures, opportunities abound due to high levels of differentiation. In China alone, the mix of Covid policies has led to significant weakness in some sectors, while others remain relatively robust. Likewise, we anticipate increased opportunities on the local rates side as inflation peaks in some countries.
Conversely, in countries such as Turkey, the ineffective monetary policy could further exacerbate inflation and put more pressure on the currency and in turn the banking sector.
On the distressed side, while we maintain high conviction in select names in the sovereign space, along with certain corporate names, we are cautiously watching developments in some other areas where we expect further stress as a result of government policy. Corporates in China and Turkey provide two examples.
If we are successful in harnessing both the long and short opportunities in these markets, the resultant returns should be attractive.
What’s driving investor appetite for EM?
Although the asset class has seen an unprecedented amount of investor outflow, we have also seen signs of institutional investors looking to re-engage – but this will take some time to fully materialise.
Much of the interest from traditional investors has focused on hard currency assets and unconstrained total return strategies, where they do not have to commit to any single asset class at any given time – a strategy we think makes sense, given the lack of conviction they have regarding the beta of the sub-asset classes.
We have also seen momentum for low turnover/index-plus/buy-and-maintain strategies, notably from German and Dutch insurers, alongside Japanese investors who want to take advantage of the yield offered in EM.
Interest in long/short strategies has picked up in the last six months, as some investors consider allocating to hedge funds, seeking more flexibility and uncorrelated investments in their portfolios.
Click here for more information on our EM investment solutions.
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