Unlocking markets: ever-changing dynamics in emerging markets

May 21, 2024

Polina Kurdyavko, Head of BlueBay Emerging Markets and Senior Portfolio Manager, and Mike Reed, Head of Global Financial Institutions, discuss recent drivers of returns, the impact of geopolitical events and – in a year of global elections – how the team’s proposed solution for the debt sustainability of Mexico’s largest state-owned oil company has been well received by the country’s presidential candidates.


Unlocking markets: Ever-changing dynamics in emerging markets

By Polina Kurdyavko, Head of BlueBay Emerging Markets and Senior Portfolio Manager and Mike Reed, Head of Global Financial Institutions.

Mike Reed 00:04

Mike: Hello and welcome back to Unlocking Markets, the RBC BlueBay podcast where we bring you experts from across our firm, providing opinions on markets, global policy, sustainability, and macroeconomics, whilst highlighting how these feed into our investment decisions. I'm Mike Reed, Head of Global Financial Institutions. Today I'm delighted to welcome back Polina Kurdyavko, head of our Emerging Markets Fixed Income team.

Emerging markets account for around 60% of global GDP and have contributed, on average, three-quarters of global growth over the last 25 years. These factors are both strong and supportive dynamics for credit issuers, however, many investors remain cautious about allocating to this segment of the market. I'm pleased to have Polina back on the show to help explain the current dynamics in the asset class and help investors identify some of the opportunities that exist. Welcome back, Polina. It is great to have you here again.

Polina Kurdyavko 01:04

Polina: Thank you, Mike. It's a pleasure to be here.

Mike Reed 01:06

Mike: When you last appeared on the podcast about 12 months ago, since then we have had a rollercoaster ride in U.S. bond markets, which has had an impact on many emerging market bonds, as many are denominated in U.S. dollars. After rising steadily through the summer of 2023, yields fell sharply as we approached year end, as investors anticipated rate cuts from the U.S. Federal Reserve. This pattern then went into reverse from the start of 2024, and in May 2024, U.S. five-year yields are about 100 basis points higher than they were 12 months before.

This has created a challenging market for fixed income investors. However, despite these headwinds, emerging market bond indices have generated high single digit returns over the period. I'd like to know, what has driven these returns and does the investment climate remain favourable?

Polina Kurdyavko 01:56

Polina: You're correct, Mike. When we think about the return of emerging market fixed income indices, just looking at the hard currency sovereign index, for example, over the last 12 months, we've registered a return very close to 10%. However, when we think about the breakdown of that return, you have very different streams of returns from investment grade-rated securities and high yield securities. In fact, the high yield segment of the market delivered over 20% return over the same period, and ultimately was the main driver of positive return.

Why did we have a situation where the return of the high yield segment of emerging market sovereign debt has been 20%? If you look at the three drivers of these returns, firstly, we've seen high yield sovereigns from frontier markets that returned almost equity-like returns. For example, countries like Egypt, Tunisia, Angola, over the last 12 months, delivered an overall return between 30% to 83%. That has been due to, on one hand, a strong commodity price environment, which helped the current account dynamics and fiscal dynamics in some of those countries; on the other hand, growing strategic importance of those countries.

You might have seen the deal between Middle East and Egypt, where UAE has provided a 30 billion loan to the country, which is unprecedented. Ultimately, that gives support for countries in frontier markets, such as Egypt and others, and gives comfort to investors in the debt sustainability of those countries. The other factor has been the positive outcome of the restructuring in some of the sovereigns. We've seen over the last five years, relatively high default in emerging market sovereigns in countries like Ecuador, Argentina, Zambia, going through restructurings.

The restructuring outcome has been successful where, for example, in countries like Zambia, investors realised over $0.70 on the dollar in terms of return, which is quite high compared to the historical recovery of $0.50 on the dollar. That meant that these countries also delivered very strong returns, with Zambia and Ecuador being up between 50% to 60% over the last 12 months. Now, you might ask me on the third point, given the strong performance of these countries, how long can it last

In our view, we can still see high single digits to low double digits returns from hard currency emerging market fixed income, given that the starting point in yield on the index level is still close to historical highs of between 8% to 9% and over 11.5% for the high yield segment of the market. Yet, if we look at the next 12 months, we would expect a zero default rate in emerging market sovereign debt, given positive dynamics on the commodity front, as well as geopolitical benefits that a lot of emerging markets have experienced over the last 12 months.

Mike Reed 5:18

Mike: That's really interesting to hear. It's very clear to me that it's not a homogenous market. I think, as you highlighted, the ongoing yield contributing to returns is incredibly important, even in an environment where U.S. core interest rates don't really move one way or the other. Carrying on, and looking more to the political side, over the last 12 months, the geopolitical scene has arguably deteriorated. In addition to the ongoing war in Ukraine, we have the added conflict in the Middle East with Israel and Hamas in the Gaza Strip.

The invasion by Russia of Ukraine caused a huge spike in global inflation, but the economic impact of the situation in Israel and Gaza has been much more muted, despite the importance of the Middle East to global energy supply. We're all aware, obviously, of the tragic humanitarian situation, but why has the flare-up not created more of a global economic shock? Are there more localised implications for countries and companies within your areas of investment activity?

Polina Kurdyavko 06:18

Polina: I would say that from the economic and geopolitical perspective, emerging market countries overall have been benefiting, unfortunately, from the recent conflicts, both in the war in Russia and Ukraine and escalation between Israel and Hamas. Let's think about what are the usual channels.

Firstly, commodities. If you think about countries like India, ultimately the war in Russia and Ukraine meant that India was paying much lower for its gas that it was importing from Russia than before. If you think about countries like Mexico, they've benefited from nearshoring between Mexico and…, in other words, Mexico and U.S. trade has increased, as the tensions between U.S. and China have increased as well. Ultimately, Mexico became the preferred supply, if you will, for some of the U.S. import goods.

Also from a geopolitical stance, I think it's important to remember that when we are at a point in time, where we have big geopolitical uncertainty, on one hand, of course, the war between Russia and Ukraine, and on the other hand, to some degree, continuous deterioration of the geopolitical relationship between China and U.S.. The U.S. needs as many allies as they can find within large emerging market economies. That's where relationship between U.S. and Middle East, relationship between U.S. and India, relationship between even U.S. and South Africa, and U.S. and Latin America have improved dramatically over the last 12 months.

The last point that I would make is the point on the developed market industrial policy. If you look at countries like U.S., Japan, Western Europe, we're seeing the current geopolitical situation translated into engagement of those countries into large industrial policies, which would require supply of commodities going forward. We're talking about three to five-year time horizons. Ultimately, that creates continuous support for commodities, even outside oil, which net-net should be beneficial for emerging markets going forward, given that two-thirds of emerging market countries are commodity exporters.

Mike Reed 08:44

Mike: Let's move from the macro now and talk a little bit about some of the technicals. There's been a lot of talk about the rising debt-to-GDP ratios in developed economies, with countries including Italy, Japan, and the United States having ratios now of more than 100%. The amount of outstanding debt and the ability to service and repay on time are fundamental indicators of creditworthiness to an investor and fixed income. How do emerging market countries compare to the developed market peers on this very important measure?

Polina Kurdyavko: 09:18

Polina: I think that when we look at just the ratios, not surprisingly, generally the ratio of debt to GDP in emerging markets would be on average half that, if not less than, the comparable ratio for developed economies. However, I think that in addition to this ratio, we also have to consider three other factors.

Firstly, it's the funding currency for debt in individual emerging market countries. That has been the main shift in emerging market economies over the last two decades, where today over 85% of funding in emerging market countries is done through local currency. Reliance on local currency reduces vulnerability of the country to external shock.

Secondly, it's the policy mix. It's the fiscal and monetary policy which defines policy credibility. I would say the biggest improvement in emerging markets over the last decade has been much more orthodox monetary policy, which is why emerging market central banks started to hike almost two years before their developed market counterparts and have been successful in tackling inflation. Furthermore, despite the fact that we've had Covid and big economic shocks, emerging market economies have spent less of their fiscal, if you will, buffers, in order to protect the economy. Therefore, generally, we've seen healthier balance sheets, both from a fiscal perspective and more orthodox monetary policy.

Now, last but not least, is the cost of access to liquidity. When I think about the access to liquidity, it's not only the price for that liquidity, and we know the price has gone up, but it's also finding the lenders of last resort, which is important in ability for emerging market governments to repay their debt.

While the cost has gone up in dollar terms, it's also important to note that actually, largely, geopolitics have increased the availability of lenders of last resort to emerging market countries, in particular, just the recent example of Middle East being one of the big geopolitical players who is now providing additional support to countries in more vulnerable jurisdictions, such as frontier economies.

All of this translates into the fact that, most likely, emerging market sovereign debt will experience zero default rate over the next 12 to 18 months. And that, against almost double digit yields that we're witnessing in dollars for the asset class, makes an attractive investment proposition.

Mike Reed 12:13

Mike: Yes, I'd have to agree that if something that's yielding double digits and zero default was predicted over the next 12 months, it’s a very compelling investment outlook. Also, I was struck by the fact that 85% is now funded in local currency, which is a figure that I wasn't aware of. I think that means that they're now much less of a hostage to fortune or less hostage to central bank policy from a foreign power. I think that's very interesting.

I would like to move into politics now. I think you touched on the U.S. earlier, but now we've got the U.S. election now. It's not far away – it's in November. Polls are predicting a return to the White House of the Donald. In his first period in office, President Trump was well known for his hawkish stance to foreign nations. If he returns to power, could this be a negative factor for emerging markets and their debt?

Polina Kurdyavko 13:05

Polina: When it comes to the U.S. elections, one of the candidates, Donald Trump, outlined three clear priorities: higher tariffs, lower taxes, and border control. Those three measures have one thing in common: they're all inflationary. To us, when we think about the impact of Donald Trump as a potential next president, the key impact would be on the inflation trajectory in the U.S. on the back of these elections. I think that will impact, of course, the Fed policy. That will impact risk assets more broadly, not necessarily specifically emerging market risk assets.

Therefore, we will be more cautious on the direction of core rates, with that outlook. However, when we think about the direct impact on emerging market economies, I would say that the tariff hikes are something that could create volatility in the end. The key question is the magnitude of those hikes. In fact, I would say the market expects the tariff hikes on some goods in China, Mexico, but whether it's 10% or 100% makes a big difference. That's something for us to watch.

The second point that I would make is let's not forget that Donald Trump is a dealmaker. You might have heard him saying that if he is the president of the United States, he will end the Russia-Ukraine war overnight and sit down both countries to find a solution. Now, of course, this is easier said than done. To me, it feels that there's also a potential benefit from Donald Trump taking a much more pragmatic approach to a number of issues, be they tariffs or geopolitical risks. Removing the uncertainty often is the best way for risk assets to perform, which we could see next year.

Mike Reed 15:07

Mike: Let's stick with President Trump. We all recall how vocal he was around building the wall between the U.S. and Mexico, and his focus on encouraging U.S. companies to onshore their manufacturing plants. I know that you recently visited Mexico on one of your regular research trips. I'd be interested to hear how this large emerging market economy is faring, and what are some of the challenges and opportunities you discovered on your visit?

Polina Kurdyavko 15:34

Polina: I would start by saying that one of the biggest surprise to the policymakers in Mexico, and in a number of other countries like Brazil, India, and a few others, is the pace of growth. In fact, Mexico is growing at one of the fastest paces that I've seen over the last two decades or in my career. I would say even Mexicans are surprised by the pace of growth, because if you think about Mexican monetary policy, it has been very hawkish. If you think about Mexican fiscal policy, the current president, López Obrador, is known for tight fiscal policy, and yet you're seeing very healthy growth and very healthy consumption.

A lot of it has been driven by domestic benefits, for example, increase in minimum wages, increase in remittances, growth, most importantly, of the domestic pension fund system and domestic investor base, as well as external benefits, such as near-shoring benefits that I mentioned that came over the last few years. Now, let's also not forget that Mexico is also going to go through elections over the next few weeks. These are, while expected elections, nevertheless important elections, because if you think about the candidate that is rumoured to be the winner of the elections, Claudia Sheinbaum, her policies are likely to be more focused on sustainability, unlike the current president.

Also, it's likely that we'll see a rapprochement between the U.S. and Mexico, given the current starting point, which I would say is pretty low in terms of the bilateral relationships. To me, it feels that despite the border talk, which of course creates tensions between the two countries and also negatively reflects on the risk assets, I would dare say that regardless of who wins U.S. elections, from an economic standpoint, Mexico is in one of the best positions we've seen in years.

To me, actually, the biggest challenge for Mexico is addressing the debt sustainability of its state oil company, rather than the tensions between the U.S. and Mexico. Here, I'm actually pleased to say that we've discussed with some of the members of the potential new administration if they were to win, the proposal that we've put together on re-profiling the debt of its ‘Mexican giant’. We've got a very positive reception, both from actually the current team, in terms of Claudia’s team, as well as the opposition team, the company itself, its biggest suppliers, and its biggest lenders. What makes us even more excited is the fact that there is a chance that we might see a re-profiling and an improvement of the debt profile of the Mexican state-owned oil company, which can translate potentially in double digit returns for investors.

Mike Reed 18:59

Mike: I'm really excited to hear about Mexico. I know that you and your team put a lot of emphasis on getting your passports out, packing your suitcases, and getting across to these regions to actually get boots on the ground and actually seeing what's going on. I think that really does show through in your investment style. If anybody wants to hear more about Polina's trip, I know there's a more detailed version on our website. Thank you, Polina. It was really interesting to get an update on emerging market fixed income. The term ‘emerging markets’ covers such a broad range of countries and economy. It was fantastic to hear your views as a specialist.

Polina Kurdyavko 19:34

Polina: Always a pleasure. Thank you very much, Mike.

Mike Reed 19:37

Mike: Many thanks for listening to the show. If you've enjoyed it, please like and subscribe on your podcast platform of choice. Next month, I'll be joined by Andrzej Skiba, head of our U.S. fixed income business. With the upcoming U.S. presidential election and the path of interest rates both areas of intense investor focus right now, his views on their impact on both U.S. and global fixed income are definitely worth listening to. Thank you once again for joining us today. Good luck and goodbye.


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