Carmen Altenkirch and Nafez Zouk report back from the recent International Monetary Fund/ World Bank meetings in Marrakech on the implications for EMD investors.
Read this article to understand:
- Why US rates hold the key for EM debt investors
- Why healthy fiscal metrics and sound macroeconomic policies are more important than ever
- Why China is an ongoing source of concern to policymakers and investors
The mood at the International Monetary Fund (IMF)/ World Bank meetings in October may have been less downbeat than in the recent past, but concerns over the negative impact of high US interest rates on emerging market (EM) countries’ finances persist.
Aviva Investors’ emerging-market debt (EMD) analysts Carmen Altenkirch (CA) and Nafez Zouk (NZ), who attended the meetings in Marrakech, Morocco, give us insight into their discussions.
Following a bruising couple of years for investors, they say 2024 should offer the prospect of positive performance for the EMD asset class so long as US interest rates begin to stabilise. Nonetheless, investors must remain alert to individual countries’ specific circumstances.
Bottom-up fundamentals will be especially pertinent in an environment of monetary easing, but still-strong headwinds, with multiple challenges including growth scarring, the financing of the energy transition and a more fragmented geopolitical landscape.
How would you sum up your meetings in Morocco?
CA: The tone of the meetings was less pessimistic than at the previous two get-togethers, where concerns over the fallout of the Russia-Ukraine war and then the US regional banking crisis were uppermost in delegates’ minds. That said, there was a concern the outlook for poorer nations would remain challenging next year, particularly if US rates remain elevated.
NZ: There were a few key themes to emerge from our conversations with policymakers in Marrakech. First, there was a widespread belief inflation has not been vanquished.
Additionally, worries were expressed that expansionary fiscal policy in the US and other developed countries would complicate central banks’ efforts to conquer inflation and therefore keep global interest rates higher for longer. That would jeopardise capital flows to EM countries and put currencies at risk, potentially fuelling inflation again. And there was palpable concern over unfolding geopolitical risks, rising protectionism and the fragmentation of trade and global economic linkages.
How do you see events unfolding in light of your conversations?
NZ: Global output has held up better than expected, led by a resilient US economy. While China’s economic performance has been disappointing, a series of supportive policy measures are likely to ensure Beijing meets its own five per cent growth target, which will remove a headwind for growth in other emerging economies.
Although there is some evidence that tighter financial conditions in developed economies are starting to impact economic activity, deep recessions seem unlikely. That suggests the recent uptick in food and fuel prices is unlikely to derail the trend of declining inflation in EM, especially given high real rates.
CA: The focus between now and the end of the year will be all about navigating the challenging external backdrop. EM currencies have been under pressure as markets reassessed the prospect of cuts in US interest rates. Investors need to judge which countries have adequate external buffers and sound economic policies when assessing the risk/reward associated with choppy external waters.
We are more optimistic on the prospects for EMD returns in 2024. As and when US bond yields peak, we see upside potential for EMD markets in absolute terms and relative to developed bond markets, particularly if markets sell off further into year end. Being selective remains key, as EM nations face a series of challenges.
NZ: Whereas in the past the IMF has painted a fairly upbeat picture in terms of EM nations’ medium-term prospects, it now acknowledges there are several sizeable risks on the horizon. Although conditions have stabilised following the shocks delivered by COVID and the war in Ukraine, countries will have to contend with structurally higher interest rates for the foreseeable future.
That could depress economic growth at a time when tackling climate change and funding the energy transition is set to place a burden on public finances. On top of this, developing countries are worried rising protectionism, amid geopolitical tensions, could dampen export demand, depriving them of a source of growth that has proved beneficial for the past three decades.
Does the US rate outlook change how you’re assessing opportunities in EM? And could this push more countries into default?
NZ: Higher-for-longer US rates makes bottom-up fundamental analysis even more relevant. With real rates rising in developed countries, EM nations face being crowded out as they struggle to compete for international capital. Those with healthier fiscal metrics and sound macroeconomic policies are best placed to avoid this.
As the first phase of monetary tightening draws to a close, fiscal policies will become important to monitor next year, especially as growth starts to slow. Countries that strike a balance between supporting growth without compromising inflation and worsening their fiscal metrics should be relatively more attractive.
CA: For high-yield issuers, avoiding default may come down to their ability to access multilateral finance, their willingness to engage with the IMF, and whether they have rich friends or opportunities to privatise businesses. If growth continues to weaken and capital markets remain closed for an extended period, expect more countries to be pushed into default. For instance, Pakistan could be at risk of default within the next 18 months should it fail to reach an accord with the IMF following the upcoming elections in February.
That said, while defaults are attention grabbing, this risk is priced into most countries’ debt. Our attention is instead focused mainly on countries at risk of having to pay materially more to issue debt, and where yields could rise substantially.
Mexico is a case in point. The country is injecting billions of pesos into Pemex, as it battles to keep the world’s most indebted oil company afloat. Pemex owes creditors more than $100 billion, equivalent to eight per cent of Mexico’s GDP. The country’s central bank has adopted a hawkish stance, making it clear it is in no hurry to cut rates until the country’s fiscal position improves.
Where do you see the biggest opportunities in EM over the next six months?
CA: While EM yields, relative to DM bonds, do not look especially compelling, nominal yields are far from unattractive relative to history, particularly in higher-rated market segments. At the other end of the spectrum, distressed and defaulted debt also offers value on a selective basis.
While investors may need macroeconomic storm clouds to lift before realising significant upside potential, countries like Egypt, which we expect to muddle through, and Ecuador, which has been overly penalised for political risk, could provide interesting opportunities over the medium term.
NZ: Timing will be key for investors in local-currency EMD. Even if inflation seems likely to fall in most countries, tighter US monetary policy will ensure central banks adopt a cautious approach to cutting rates and keep real policy rates considerably higher than historical averages. As and when US Treasuries stabilise, EM local-currency bonds should perform strongly.
Which country could be the biggest surprise in 2024?
CA: Hard as it might be to imagine now, Argentina could very well be the trade of 2024. The South American country has no money, no rich friends and no credit cards. Its bonds are trading at little more than 20 cents on the dollar. This is justifiable given the non-negligible risk that the social and political cost of the necessary fiscal tightening is too great and the country will opt instead to default.
However, the message from presidential hopeful Javier Milei, whose key advisor we met at the IMF meetings, is that he is willing to tackle years of irresponsible economic policy and consolidate the budget. While Milei is portrayed in the Western media as a lunatic figure, we think underneath that perception he is a clever and shrewd politician, who might just succeed should he win power in impending elections.
NZ: Turkey is another country that could provide a positive surprise. The country’s new economic team was on a charm offensive in Marrakech, keen to explain their roadmap for unwinding the unorthodox macroeconomic and monetary policies that brought Turkey to the brink of successive crises in recent years.
Whether the turn towards orthodoxy endures is a key question for investors. Actions speak louder than words, but if a rebuilding of trust is established, a virtuous cycle could ensue that allows investors to take part in Turkey’s high potential growth prospects.
If US growth slows more than expected next year, can China pick up the slack?
NZ: EM economies tend to be intricately linked with the Chinese economic cycle, which explains why China’s growth prospects were top of mind in Marrakech. While stimulus measures should mean the government hits its growth target this year, China’s economic problems are more structural in nature. Local governments are heavily indebted while several big property developers are struggling to stay afloat following the collapse of the country’s real estate bubble.
Beijing doesn’t appear to have a coherent plan for resolving the crisis. Without this, it is hard to see how China will get onto a stronger economic footing and provide the world with a marginal source of demand as global activity slows. That has policymakers worried given the extent to which many EM countries depend on China as a source of export earnings.
Chinese debt is likely to stay unloved amid ongoing concern about the country’s role in stoking tensions with the West and other nations, most notably Taiwan, the increasing level of Chinese state intervention in the private sector, and the less than rosy outlook for the domestic economy.
Your hard-currency EM debt strategy celebrates its 20th anniversary this year. Looking ahead to the next 20 years, what do you expect to be the key considerations for investors?
CA: Firstly, institutions, and their impact on politics and policymaking, matter more than economic growth or any other macroeconomic variable you may follow. Counties with strong institutions are best placed to deal with shocks, which are a regular occurrence in EMs.
Secondly, while history matters – because countries that default once are more likely to default again – it is important to keep an open mind because situations change.
Thirdly, investors need to be flexible and not afraid of changing their opinion. Focus on identifying and assessing risks and opportunities, but once these have materialised, be prepared to re-assess. Today’s risky EM country could well be tomorrow’s opportunity.
Finally, address any biases. Simply because a country has a high credit rating and is perceived as being low risk does not mean it has a favourable risk profile. Price matters.
