Navigating emerging markets debt in a currency driven world

Jonathan Boyd

We currently tend to prefer emerging markets credit and that position is based on several factors.

Firstly, if we look at valuations, they are attractive, particularly relative to developed markets. Compared with their own history emerging market spreads are towards the high end of the 5 yr range.

Technical factors are supporting emerging markets credit as well. For example, there remains a lot of liquidity across EM markets, against a backdrop where investors are seeking both yield and diversification. This is evidenced by significant positive inflows into the asset class recently.

Meanwhile, extraordinarily low interest rates across developed markets are anchoring yields incredibly low, particularly in Europe, which makes the yield on emerging markets even higher by comparison.

Another reason for our preference for emerging markets credit is that it is denominated in US dollars and will tend to benefit from the strengthening of the currency and search for dollar assets, which is otherwise a fundamental headwind for the overall EM asset class.

Within EM credit we have a preference for higher credit quality. For example, we tend to lean towards commodity importers, sovereigns with strong balance sheets and corporates with less cyclicality. We also monitor for promising turnaround stories that have the potential to be very profitable, such as reformed countries.

We can’t deny that broadly the EM space is facing significant challenges. However, we would argue that they are largely priced in. There may be more adjustment to come, particularly as the timing for a US Federal reserve rate increase remains in question, but we think credit will do relatively better as the bulk of the adjustment will happen in the local currency market.

When we think about the broader challenges, we have to consider the strong US dollar as a major factor. Historically it has been a negative for margins and a negative for the balance sheets. However, it is worth remembering that this is not new ‘news’ and it is largely priced into market expectations. A second macro headwind for EM is commodities, which have weighed on overall performance. It is not all bad because 75% of EM economies actually tend to benefit from lower commodity prices.

Nevertheless, investor sentiment tends to link weak commodity prices with EM weakness. We’ve seen a fair amount of adjustment already which is the good news, but we probably still have more to go. The final headwind for emerging market economies is the pattern of economic divergence, with developed markets outperforming and emerging markets economic growth continuing to deteriorate due to the deleveraging across EM countries such as China, which continues to attempt to rebalance their economy to be less dependent on credit, translating into lower growth in economies in EM. Again, we are pricing that in slowly but surely.

Given all of this, it makes sense to prefer higher quality credit and seek countries and issuers who are better positioned to ride out the business cycle, protected from commodity exposure and have strong balance sheets. So where are we finding opportunities?