EM Debt: What happens when emerging countries have emerged?

Historically, investing in emerging markets (EM) has implied accepting higher volatility and risks, including political instability and currency devaluations. Yet, over the past decade, the structure and drivers of the asset class have changed.

Today, an EM debt (EMD) investment can be made based on the perspective for sustained economic growth, ongoing governance improvements, and a more mature structure for debt issuance, characterised by increased issuance in local debt markets versus hard currency (external) debt markets.

In this article, Ostrum AM’s EMD experts Brigitte Le Bris, Sebastien Thenard and Clothilde Malaussene share what they see as the key risks and opportunities for EM investors.

How are you thinking about EM in 2024? Do any countries stand out?

Brigitte Le Bris (BLB): “In the short term, the main risk is not EM related, but instead what will happen in the US. Are we facing a hard or soft landing? At Ostrum AM, the view is that we will get a soft landing well-orchestrated by the Federal Reserve. This means that after the 50bps rate cut in September, we believe the Fed will reduce rates again by another 50bps in December and that we will also have more rate cuts next year. We recognize, however, that given the resilience of US activity, especially in the labour market, we may have to revise our outlook.

“That said, growth in EM continues to outpace DM [developed markets]. The outlook for growth in China was seen as a concern given that growth was forecasted below 5% by most market participants before the large stimulus announced in late September¹. However, slower – or higher – growth in China does not necessarily impact significantly an EMD investment as the EMBIG-GD hard currency index includes only a small weight in China, at just 3.18%, and the same is true for the local market debt index, GBI-EM, with China representing 10%².

“For many years, EM have been dependent on international flows. An investment decision started out with an analysis of the US dollar and an opinion on where we were in the global economic cycle. Today, there are notable endogenous forces within EM for investors to consider. Countries have matured and have become more autonomous, thus more financially independent, and therefore, less tied to the US dollar.

“Meanwhile, numerous EM now have local pension funds to finance their growing local debt issuance. All of which adds confidence to our view that the performance of the asset class can continue to outpace DM bond performance in the years to come.”

Sebastien Thenard (ST): “When I started my career in 1997, one of my first encounters with managing risk was the Russia crisis when the Rouble was devalued and there was a forced restructuring of domestic government debt. This situation led to an overall reassessment in credit markets and EM debt in particular.

“Later, in 2003 and 2004, the story for EM significantly improved when local debt markets started developing. And we have now reached the point where some countries, like South Africa, for example, are issuing a large part – more than 75% – of their debt in local currency, the ZAR [South African rand]³. Mexico and Brazil are other examples of countries with very large sized local bond markets, and we also find active local debt markets in Morocco in Northern Africa⁴.

“So, many EM countries have the possibility to arbitrage between borrowing in dollars or in local currencies and most decide to mix both. Issuance into international markets – USD or EUR – is perceived as a barometer of good governance, and therefore countries that issue large amounts of local bonds, like South Africa, still continue to go to the international bond markets for this reason. Issuance in both markets is a win-win situation. Countries that issue in both can attract investor appetite, indifferently, either in an external currency or a local currency.”

Which indicators are you keeping a close eye on for EM investments as you look beyond 2024 and into the longer term?

Clothilde Malaussene (CM): “The global macro-outlook is and will always be a key consideration for the EMD asset class along with relative value analysis that takes into consideration the yield differential to DM peers like the US Treasuries. In addition, performance of the asset class is positively correlated to growing business activity from multinational corporations. And finally, specifically for lower income countries, we keep an eye on the IMF’s support policies. 

“Anticipating flows into the asset class helps to guide our positioning. We constantly monitor what instruments or asset classes are competing with EMD. US T-bills, renumerating 5%, for example, are competition for flows along with equities or high-yield bonds. And of course, specific to the asset class, we need to anticipate if flows will go to local currency bonds versus hard currency bonds and why they are doing that.

“In the end, it will come down to a country-by-country analysis. We apply the usual debt matrix which includes GDP, inflation, fiscals, and current accounts, but we also consider governance as critically important. How does the government drive growth? What reforms are they taking? How do they tackle social and environmental concerns?

“Climate change is of significant interest, posing questions around how local governments are tackling the issue, how they are increasing the level of education, and how the country tackles security, given some of the levels of criminality in emerging countries. All the ESG considerations are equally important.

“For this reason, it can sometimes be difficult to look only at quantitative measures. We believe it is key to also apply qualitative analysis by reading policy documents and engaging with government officials. All of these considerations are included in our country analysis.”

What do you think about the argument for retiring the concept of ‘emerging markets’ as an asset class?

ST: “Seasoned EM investors are, for sure, frustrated with the term ‘emerging markets’. This term made sense at the onset when there were only six or seven countries to invest in, however, over the years, the universe has broadened out to include around 80 countries. Today, EM is clearly a term that could be misleading when a significant part of the universe is rated investment grade. Other options could be to consider a term more in line with the IMF’s World Economic Outlook classification, ‘low income to middle income countries’, yet market participants tend to like simple acronyms.

“For example, in 2016, the term BRICS (Brazil, Russia, India, China and South Africa) emerged to invite investors to consider an allocation which later proved to be an imperfect representation as the regions are much more diverse and complex than the acronym suggests. Moreover, by putting a focus on the BRICS, other emerging countries, were often forgotten, as was the case with Africa.“So, yes, there is now debate as the term ‘emerging markets’ no longer does justice to the wide array of constituents within the various EM indices. In terms of country ratings for example, within the same index, you have China and some Middle Eastern countries with have very high ratings, along with other countries like Venezuela, who are still considered in default.”

BLB: “In the future, we are betting on a reshaping of the countries that constitute the EM indexes. For example, it is likely we will see an increased number of lower income countries with the EMBIG-GD index, as these countries will need to go to the international markets [external debt] for financing.

“Local debt markets and the local debt market index, on the other hand, will likely be represented more and more by higher income [higher rated] EM countries. However, we believe the two universes will continue to coexist, considering their associated risks – and therefore risk profiles – are quite different for investors: external debt is about US rates and credit whereas local debt is about FX and local rates.”