Commentary by Kristin Ceva, Managing Director, Payden & Rygel
- After a challenging 2022, emerging markets debt offers the potential for attractive yields and diversification in 2023. Investment portfolios are under-allocated to this asset class currently, with institutional portfolios around 4% to 6% of their assets in emerging market debt. Investors may wish to rethink their positioning in 2023.
- Emerging markets are too big to ignore. The asset class represents a large and growing proportion of the world economy, accounting for about 60% of global GDP in 2022 (in PPP – Purchasing Power Parity – terms).
- Emerging markets debt offers attractive yields. As of the end of May 2023, emerging market sovereign yields are 8.6%, emerging market corporate yields are 7.5%, and emerging market local yields are 6.5% (though with significant dispersion; several countries offer 8-12% local yields).
- Emerging markets debt isn’t as risky and underdeveloped as many investors believe. About 60% of the sovereign dollar-pay index is investment grade, and the percentage is even higher among emerging markets corporate bonds (67%) and local currency bonds (75%).
- Emerging market debt delivers greater diversification benefits compared to emerging market equity, and with much lower volatility. Consider that while emerging market equities have generated higher absolute returns, when adjusted for the volatility, emerging market debt returns are about 40% higher than emerging market equities.
· The largest emerging market sovereigns and corporates have been resilient in the face of rising rates and tighter financial conditions. This is because central banks got ahead of inflation with proactive rate hikes, and corporate balance sheets have been well-managed. - EM local interest rate and currency markets are particularly compelling in the current environment. This is due to: 1) high EM rates (reflecting proactive EM central banks); 2) decelerating inflation momentum; 3) the US Fed nearing the end of its hiking cycle; 4) a long run of USD strength leading it to overvalued territory; and 5) relatively resilient EM growth amid a likely US slowdown.
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We think that China will need to more aggressively stimulate the property sector, given the continued weakness in the space and the fact that it accounts for 25% of China’s GDP. However, the timing on this is not easy to call given Xi’s reluctance to lose the progress they’ve made in tackling the moral hazard issue of bailouts. The government needs to create more confidence in property developers and do more to improve home sales.
China’s slowdown will impact the rest of EM in different ways than it has in the past due to its ongoing transition from a manufacturing-oriented economy to a services-led economy. It will be less impactful than in the past to commodity-exporting countries, and more impactful to trade-oriented countries (particularly in Western Europe) that export to the Chinese consumer sector. In addition, China’s very low stocks of commodities have it to re-stock and potentially stockpile, so China’s slowdown has not had a large commodity effect. Current activity indicators show EM-ex China growth to be strong and improving versus developed country growth.