Emerging Markets Debt: Is There Still Gas in the Tank?

Emerging Markets Debt: Is There Still Gas in the Tank?




by Rob Drijkoningen, Co-Head, Emerging Markets Debt, Neuberger Berman

Back in November, emerging debt markets were under the gun. In the run-up to the election of Donald Trump as U.S. president, there was a reflation trade that led to an increase in both nominal and real interest rates. Real interest rates typically inflict the most pain and EM debt was hurting. Fast forward six months, however, and the asset class is looking far healthier. Concerns about the Trump administration’s “America First” stance and its policies on trade have eased considerably. Indeed, the recent U.S.-China trade deal, despite skepticism over an apparent lack of substance, has greatly reduced the possibility of a mutually destructive trade war between the two nations.

More generally, cyclical indicators in emerging markets have been ticking up since the start of the year and even countries such as Brazil and Russia, which suffered most in 2014 and 2015, are now showing signs of recovery. Current controversy aside, Brazilian President Michel Temer’s ambitious reform program, which includes pension and labor changes along with greater foreign investment, is having a positive effect. Growth is improving in Russia, too, albeit slowly. Elsewhere, Argentina, India, Indonesia and Mexico have all seen impressive reforms implemented over the last couple of years. With currency adjustment and interest rate increases, many EM countries have seen their current accounts narrow dramatically.

Indeed, in some cases it’s been a remarkable transformation. Couple this with a synchronized global recovery and one begins to see why the outlook for emerging markets has improved and cross-border flows into bonds exceeded $20 billion in April.

True, many EM countries are heavily dependent on commodities, which had a negative impact on them back in 2014 when oil prices collapsed. However, many of these countries have considerable freedom in their policymaking, and were able to allow their currencies to depreciate in order to protect their credit profile. As a result, they didn’t fall off a cliff when oil prices declined, and now commodities are helping them to recover.

Risky Business

Of course, there are plenty of risks still out there, particularly in sovereign bonds. Venezuela is vulnerable, for example. Defaults often result in regime change, so the Maduro government continues to draw upon its foreign reserves in order to pay bond holders. But reserves are running low, and its next big payment is due this autumn. South Africa also has problems: downgrades due to the firing of its finance minister, as well as weak growth and burdensome state-owned enterprises. More generally, if the U.S. economy were to slip into reverse (something few are currently projecting), that would also have a negative impact on emerging markets debt.

Overall, however, the outlook for emerging markets debt remains positive. Growth is more sustainable, current account deficits have been greatly reduced and vigorous reforms are gaining momentum.

In terms of market segments, we believe sovereign and corporate debt still look attractive on a relative basis, although spreads have tightened considerably. Currencies have been on the way up, although generally we think they are under- rather than overvalued. Interest rates are still at reasonable levels, and various EM central banks, such as in Russia, Brazil and Colombia, are easing rates or will likely be easing given prevailing output gaps—rising inflation in aggregate still looks like a distant event rather than an imminent probability. In 2016, there were elevated default rates in the EM corporate space, led primarily by issuers in Latin America following the collapse in mining and energy stocks. But default levels this year have fallen.

I’m often asked why it makes sense to invest in emerging markets debt. First, I say that investors generally are underexposed to this asset class. The emerging debt market now exceeds $18 trillion and is growing rapidly as new issuance comes to the market. Second, it’s hugely diversified in terms of countries, currencies and industry sectors. Third and most important, it currently presents a yield advantage over developed market bonds. With fundamental improvements across EM countries, we believe that this risk premium could narrow over time.

 

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