Polina’s Perspective: Emerging markets – a high coupon affair or true love?

Have you ever fallen in love? The feeling of happiness and euphoria provides plenty of scope for optimism and long-term planning. Yet the challenge lies in making the transition from this highly emotional state to one of long-lasting love. Patience, compromise, communication and commitment are key.

Investors have certainly been falling in love with the carry that emerging market fixed income investments have to offer. The yields of both the hard currency and the local currency fixed income indices are trading close to their 20-year highs, in many cases, reaching double-digit levels. The increase in risk appetite for emerging markets can also be seen in the reversal of flows since the beginning of the year with emerging market (EM) fixed income registering USD2 billion inflows year to date, albeit lagging inflows to the EM equity and US investment grade (IG) debt markets. The key question remains whether this trend is a tactical phenomenon or a structural shift.

"Investors have certainly been falling in love with the carry that emerging market fixed income investments have to offer."

There are certain elements that point in the direction of structural long-term changes. In addition to monetary policy orthodoxy and a supportive commodity price environment, we are also witnessing an interesting geopolitical reshaping of the world. The lukewarm relationship between the US and China is unlikely to improve in the short or even the medium term. However, given the interlinkages between the two countries, we are equally unlikely to see a sharp deterioration in the economic activity between the world’s two largest economies. What does this mean for the rest of emerging markets? In our view, the current geopolitical situation presents several advantages for large emerging market economies such as India, Indonesia, Brazil, Mexico and Chile to name a few.

In the new geopolitical order, these allies become strategically more important. Given the ongoing Russia-Ukraine war and tensions between the US and China, the West needs as many allies among emerging market countries as possible. This is an opportunity for these emerging markets to change the rules of the game and dictate their terms when it comes to trade deals, portfolio flows and the level of tolerance vis-a-vis policy conduct in particular jurisdictions. Does a structural shift in positioning for these emerging market economies concerning their geopolitical stance also translate into portfolio flows? A few months ago, in a piece called ‘Frontier fortunes,’ I wrote about certain emerging market economies that are likely to struggle in the current environment. Is there a constructive trajectory for more established emerging economies?

It is interesting to explore the consequence and the cost of policy credibility. Emerging markets have by and large been early to the hiking cycle. For example, in Latin America, most central banks now have double-digit policy rates, while inflation is already in a single-digit zone and on a declining trend. The immediate consequence of policy orthodoxy has been the stabilisation of domestic flows and currencies. We have already seen the market starting to respond to this through a higher focus on the local currency opportunities with EM local currency bond flows exceeding that of hard currency flows year to date. The JP Morgan Emerging Markets Global Bond Index has been a strong performer this year registering +7 total return year to date (8th May 2023).

While appealing to investors has its benefits, there is also a cost to restrictive monetary policy. For example, in Brazil, a policy rate of 13.75% is well above the nominal GDP growth rate of 8.5% as of December 2022. The Brazilian central bank Governor is adamant that the policy rate is appropriate, pointing to uncertainty on the outlook for inflation and fiscal discipline, as well as a relatively healthy state of the economy. However, with Brazil having the highest public debt to GDP ratio among large emerging market economies at 73% investors could start to worry about debt sustainability and growth implications. Indeed, every additional year of current policy rates in Brazil would add 1% to 2% to its debt-to-GDP ratio and have negative growth implications. In this environment, one has to navigate a fragile equilibrium between policy credibility and sustainability. In Colombia, meanwhile, policymakers are mastering a bipolar pattern where on the one hand the government is trying to maintain fiscal discipline and monetary orthodoxy, while on the other hand, the left-leaning president proceeds with a cabinet reshuffle, replacing a market-friendly Minister of Finance, among others, seeking popular support and votes, but creating more market volatility.

While investors can often be attracted to double-digit yields, they should also be careful what they wish for. The double-digit cost of debt is generally not sustainable for countries or companies over the long term. If this trajectory continues, the only winners will be restructuring firms. I believe emerging market policymakers have gained a lot of credibility by being on the front foot of the hiking cycle. The challenge now is transition from a stance of tight monetary policy and a relatively loose fiscal policy to counter the effects of the Covid pandemic and the Russia-Ukraine conflict to more dovish monetary policy and more conservative budgets.

"The challenge now is transition from a stance of tight monetary policy and a relatively loose fiscal policy to counter the effects of the Covid pandemic and the Russia-Ukraine conflict to more dovish monetary policy and more conservative budgets."

In this scenario, investors can register superior returns in EM fixed income assets compared to some of the developed market credits, where tight liquidity is likely to continue to weigh on companies’ margins and debt sustainability may be challenged in some private equity owned businesses. I believe most emerging economies are in a position to deliver this transition, from a tactical allocation (‘high coupon affair’) to a structural allocation in investors’ portfolios (‘true love’). However, as always, execution is key.

The current environment can also create alternative sources of funding for emerging markets through private debt markets and blended finance. Given the need for capital for government-sponsored infrastructure projects, particularly in poorer emerging market countries, we could see market participants developing innovative solutions to bridge the gap that public market closure has created. This dynamic is not too dissimilar to the formation of European private debt markets over a decade ago. Even so, historically investors have been more comfortable with liquid emerging markets exposure given the volatile nature of the asset class.

Extending the liquidity time horizon would require many investors to be convinced of the trustworthiness of their partner in this long-term relationship or to have that exposure de-risked with guarantees or other backing from multilateral development finance institutions or their developed market shareholders. This would also go some way to meeting the pledges made at recent international conferences for the rich north to transfer resources to the poorer south for so-called ‘loss and damage’ from climate change.

For this, emerging market countries have to continue working on improving their institutions, in particular the judicial side including bankruptcy procedures, to become more aligned with some of the European economies, where progress has been made in recent years to improve creditors’ stance in debt restructurings. Over the coming months, ongoing sovereign restructuring discussions with countries such as Zambia and Ghana could provide investors with more clarity on how they can expect a new partnership to develop with these distressed borrowers. Should the stars align with successful outcomes, this could potentially pave the way for a new, more open and constructive relationship framework.

We are currently at the crossroads where emerging markets have an opportunity to be added to the structural allocation of investors’ portfolios, thus migrating from a love affair seduced by a high coupon to advancing into a long-term partnership and true love.