Lyubka Dushanova, Portfolio Strategist, Emerging Market Debt, outlines why investors should reassess prospects for EMD right now. Summarising what happened in EMD in 2022 and the opportunities we see for the asset class in the year ahead, Lyubka explains why we believe an indexed approach makes sense. For deeper insights see our paper below – Revisiting Emerging Market Debt: Brighter Days Ahead?
Speaker : Lyubka Dushanova
Portfolio Strategist, Emerging Market Debt
What happened with Emerging Market Debt in 2022?
2022 was a volatile year for markets and EM was at the center of this volatility. Yet when we look at performance of emerging market debt, whether it’s local currency or hard currency debt, we can see that to a large extent underperformance was driven by non-EM factors, namely the US monetary policy, which drive a sharp selloff in US treasuries and strength in the US dollar, both of which are negative for EM.
Of course, there were also EM specific factors, in particular the war in Ukraine, which affected not only the EM, but also global markets through the commodity channel. Also, with a sharp increase in refinancing costs, a number of vulnerabilities in EM were exposed and a number of EM countries had to restructure their debt over the course of the year.
Finally, China which in previous economic cycles has been the motor of growth for emerging markets saw a sharp deceleration in its GDP, registering a GCP of 3% for 2022, one of the lowest prints in its modern history.
What are the prospects for 2023?
Although 2022 was a painful year, we do think that this leaves us with a significantly improved out look for the asset class this year. If we take hard currency sovereign debt for example, we think that the story there this year, is one about carry. With a yield of over eight and a half percent for the JP Morgan and EMBI Global Diversified Index we believe the asset class offers attractive compensation for income seeking investors.
We also have to remember that the spread widening in the EMBIG index has really been drive by the high yield names in the index which represents almost half of it. The good news there is that most of the vulnerabilities, most of the negative stories have already been exposed and priced in. And so even if we see some spread volatility like we saw this year driven by market sentiment, we expect that this is going to be offset by a rally in Treasuries like we saw in March this year.
In local currency debt we think that there are good catalysts for local rates to outperform this year. And the reason for that is really because EM central banks have been ahead of the curve this time around. They started hiking rates more that half a year ahead of the Fed, and as a result EM inflation is now peaking in most places. Some EM central banks have paused their hiking cycles and we do think that some of them will even start cutting over the course of 2023. On the FX side EM FX has been undervalued versus the dollar for more than two years now but we do think that this is more of a reflection of the dollar strength rather than weakness in EM. We think that the dollar will remain volatile, driven by the Fed monetary policy and by market sentiment. And so we expect that in local currency debt performance this year is really going to be driven by the rate side.
The Benefits of an Indexed Approach in Emerging Market Debt
We believe that our indexed approach is suitable to this type of highly volatile market environment because it provides an efficient exposure to the beta of emerging markets.
Contact us at SSGA_InsightsEMEA@ssga.com
After a volatile year, emerging market debt has rallied in recent months. The recovery has not been without turbulence, but there are signs that the skies are brightening as some of the headwinds that pinned back performance have eased. We consider what investors in EM debt might expect through the rest of 2023.
EM debt posted healthy returns in a bumpy 3-month period that saw markets navigate shifting rate expectations, banking upset, and signs of peaking inflation.
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