Standing tall

One indication of the increased resilience across EM economies is the fiscal strength of high-yield issuers, traditionally the weaker economies in the universe.

This is partly a cyclical story. Many of these countries have benefited from elevated commodity prices over recent years, which has helped them to sharply narrow their current account deficits (especially in Sub-Saharan Africa).

A fall in commodity prices would cause problems for some of the weaker high-yield issuers; while reserves are higher at this point, they may not be sufficient to provide protection should commodity prices stay low over an extended period. On the plus side, countries that have shown improved fiscal discipline should be in a better position as and when new macroeconomic headwinds materialise. 

For example, many of these economies have successfully consolidated their primary budget balances back to their pre-pandemic levels, a significant achievement given the public expenditures required during the COVID-19 outbreak and the broader fiscal challenges posed by higher interest costs during the subsequent monetary tightening cycle.

Kenya, for example, has shifted to running a primary surplus over the past year, something which hasn’t happened before over the past decade. South Africa has also shifted to a primary surplus for the first time in 15 years, as the government pushed ahead with a conservative fiscal policy despite a challenging growth outlook. Argentina, a serial defaulter, finally has a government in place that understands that fiscal imprudence has contributed to the country’s regular “boom-bust” cycles.

Reflecting this, high-yield issuers have been able to return to the international markets to issue bonds in 2024. By raising new debt, countries such as Ivory Coast and Benin have been able to rebuild their reserves, and we expect Nigeria and Senegal to follow suit by tapping markets over the coming months.

Understanding which countries are likely to adopt proactive fiscal policies and maintain their discipline in a more adverse macroeconomic environment will be key in picking the winners. Our forward-looking assessment of debt dynamics through to 2029 suggests high-growth, high-yield countries, like Egypt, should see debt fall further. However, we need to pay particular attention to credits like South Africa, whose fiscal improvements could be unwound if growth disappoints, or interest rates remain elevated. Slow-growth countries like Brazil also warrant careful focus, particularly if domestic politics remains disruptive, and local bond yields remain elevated. 

The structural improvements in EM economies are another important factor in the resilience of these markets.

As well as improving their fiscal discipline and bolstering their revenue-collection capabilities by rolling out new technology, many emerging economies have strengthened their monetary policy frameworks, with central banks shifting towards inflation-targeting regimes and greater exchange-rate flexibility. EM central banks, in many cases, led the charge in recognising that inflation was less transitory than initially thought from mid-2022 onwards, raising rates and taming inflation ahead of their developed-market counterparts (see Figure 4).

Countries like Egypt, Nigeria and Sri Lanka are transitioning toward more flexible foreign-exchange regimes after learning hard lessons in previous years when they struggled with depleted reserves. Others, like Ghana and Kenya, have been operating with more flexible regimes for some time. In addition, stronger prudential regulation and supervision at both national and international levels introduced since the Global Financial Crisis means the broader macro framework is more stable than in the past.

Looking ahead, longer-term structural trends, such as the likelihood of sustained demand for critical materials needed for the net-zero transition, could further enhance the economic security of emerging economies. Many critical raw materials needed for the transition are sourced from EM nations such as Chile, which is a major exporter of copper, a key component in electricity transmission networks.

It is no secret that EM corporate giants such as Indian telecoms firm Reliance Jio and South African internet company Naspers are wielding increasing clout on the global stage.

But the broader resilience of EM companies is also worth noting. One indication of this is that default rates are on the decline: JPMorgan recently revised its 2024 default-rate expectations for high-yield companies across the Corporate Emerging Market Bond Broad Diversified Core Index to 2.1 per cent (down from 2.9 per cent). This marks the first time in four years when the default rate is projected to be below the historical average.

Prudent cash management and pragmatic corporate behaviour throughout a difficult period following the COVID-19 pandemic has been reflected in strong credit metrics among many EM companies.

While the tougher macroeconomic environment has contributed to a higher cost of capital – which is likely to have played a role in reduced merger-and-acquisition activity, lower capital expenditures and restrained shareholder returns – these factors have also enabled EM companies to maintain strong balance sheets and healthy credit metrics. 

Despite the inflationary pressures experienced during the 2023 financial year, earnings before interest, tax, depreciation and amortisation (EBITDA) margins fell by just one per cent across companies in the JPMorgan index, while gross and net leverage increased by a modest 0.2x and 0.1x over the period, respectively, attesting to strong discipline among EM companies.

Finding opportunities

Even as EM sovereign and corporate issuers appear increasingly robust, valuations continue to look attractive. Higher yields are available on EM debt following a significant repricing that took place in 2021 and 2022, potentially offering greater return potential and a cushion against future market volatility. 

Some investors have looked to cash and short-duration assets as “safe havens” during the recent macroeconomic uncertainty and market volatility. But the risk of reinvesting at lower rates looms, with policy rates expected to decline further. In this environment, and in the context of strengthening fundamentals, the relatively higher returns available on EM debt could prove increasingly attractive.

Nevertheless, while we can point to increasing resilience across EM, there is great divergence across the universe, and risks to the asset class are arguably more dynamic in nature than those in developed markets. Investors will need to adopt an active, flexible and disciplined approach in order to identify the most attractive opportunities.

These opportunities exist across the entire investable universe – not just within the higher-yielding segments of the market towards which return-chasing investors often display a bias. We believe evaluating the full opportunity set across investment-grade and high-yield is a better way to capture the best prospects.

A deep understanding of risk is also essential, because emerging markets are characterised by high levels of idiosyncratic risk, which traditional risk metrics often fail to fully capture. Expertise and comprehensive due diligence – including in-country visits to meet with key policymakers and other stakeholders – is crucial for a deeper understanding of each market and its place within the EM universe.

Finally, balanced portfolio construction is key to delivering consistent returns. Our process targets diversified sources of returns with a constant focus on risk and reward. We have a willingness and ability to avoid biases and focus on a broad range of opportunities that we fully understand because of the depth of our fundamental analysis (see “An unbiased approach to finding opportunities in emerging-market debt”).¹  This approach offers potential to achieve a smoother path of strong risk-adjusted returns and can be attractive for investors seeking to build a strategic allocation to an asset class that, as the factors explored above show, is increasingly set up for longer-term resilience.