Outlook NNIP emerging bonds

Expectations for emerging market bonds are more downbeat than at the start of 2021, but undemanding valuations, high yields and idiosyncratic opportunities give active managers plenty to work with. Allocating to countries that are well placed to withstand Fed tapering, where inflation is set to peak early on, and that combine commodity exports with strong balance sheets is likely to be a rewarding strategy in the year ahead.
Marcin Adamczyk, Head of Emerging Market Debt at NN Investment Partners (NN IP), says: “We believe it’s going to be a year for active management, especially in the first half due to the ongoing effects of inflation and Covid. It will be vital to avoid the weakest links in the emerging market universe, and there’s going to be scope to add a lot of value on top of the broad market return through regional calls, country positioning and active rotation.”

A brief recap of 2021
Last year started off well for emerging market fixed income, but the asset class wobbled as President Biden’s stimulus plan passed Congress and pushed US Treasury rates higher. Inflation started to take hold later in the year. Central banks in emerging markets had no choice but to react by hiking rates. Events in China also dented sentiment. Authorities there started to tighten liquidity conditions to push real estate developers to reduce their leverage. These problems, plus strong US growth and a rising Dollar, created tough conditions for emerging market debt.

A more subdued outlook for 2022
The consensus estimates for EMD in 2022 are downbeat. A collision of forces – the uncertainty created by a revival of Covid, Fed tightening and slower growth, the reduced growth differential with developed markets – are all headwinds for the sector in the year ahead.

Nevertheless, emerging debt is still providing attractive yields compared with much of the developed market debt universe. EMD is a diverse asset class and a combination of the macroeconomic backdrop, attractive valuations and cautious expectations means there is scope for emerging market debt to provide positive returns over the year, but it will require careful navigation.

A focus on active management – seven focus areas
Identifying high-growth countries and regions – Asia, excluding China, should grow strongly with low Covid cases and strong exports. Central and Eastern Europe should also see strong growth, as should commodity exporters. On the other hand, countries with weak growth and that have hiked interest rates significantly – like many in Latin America – aren’t going to be helped by tighter monetary policy.

Pinpointing the countries where inflation is set to peak early – Central banks in emerging markets were quick to react to inflationary pressures in 2021. It’s possible that inflation will peak in the first half of 2022. Those countries that have already raised interest rates and where inflation will fall first could be attractive to investors.

Looking for currency carry – Emerging market currencies were volatile in 2021 and provided much less carry than they have historically (a currency carry trade involves borrowing in a currency from a country with a low interest rate to fund purchases of a currency in a country with a high interest rate). We expect carry to improve now that rates are much higher. In countries where inflation starts to come down, investors will realise that rates are high and may start to buy those currencies.

Assessing which countries are best placed to weather Fed tapering – Emerging countries are less vulnerable to tighter financial conditions than in the past. Emerging markets now have current account surpluses – amounting to 1.6% of GDP in 2021 and likely to be around 1% in 2022 – on average. These are healthy figures that have been boosted by favourable developments in export-to-import ratios and rising commodity prices. Equally, emerging countries’ level of debt denominated in US dollars relative to GDP has been steadily falling in recent years.

Opportunities among commodity exporters – Commodity-exporting nations have enjoyed a substantial windfall from the sharp rise in commodity prices over the past year. It has helped emerging markets to limit the in-crease of their debt-to-GDP ratio to around 10% over the course of the pandemic, lower than for developed markets. Commodity-exporting countries with strong balance sheets have considerable scope to outperform next year.

Playing geopolitics – Market volatility in the run-up to elections is a given in emerging markets, but it often subsides after the result is known. This creates attractive opportunities for active managers to exploit. There are plenty of elections on the calendar this year: President Xi will be running for a third term in China, we’ll probably be seeing Lula vs. Bolsonaro in Brazil, and there are also elections to be held in Colombia, Hungary and the Philippines.

Capitalizing on the green transition – Emerging markets including Hungary, Chile and Egypt have issued green, social, sustainability or sustainability-linked bonds as demand for ESG investments increases. There’s also been labelled-bond issuance from corporates. If the structures of these bonds prove credible, there should be huge demand from investors looking to make an impact with their money.

Still a great diversifier
Adamczyk continues: “Investors considering where to allocate in 2022 should remember that emerging market debt can still provide useful diversification benefits to a balanced portfolio. Local currency bonds in particular have a low correlation with other fixed income classes. Furthermore, central banks have been buying a lot of corporate bonds in developed markets, but this hasn’t happened in emerging markets, so the technical picture in the two regions is different.

“Partly as a result of this buying, developed market bond prices are at historic highs, but whereas emerging market debt is cheaper – especially high yield – and doesn’t face a potential cliff if central banks suddenly stop their purchases. This could lead to an even lower correlation than has historically been the case.”

Want to read more? Please find the full EMD 2022 Outlook here.