The fixed income opportunity with "a lot more to give"

In November last year, I sat down with Grant Webster, Co-Head of Emerging Market Sovereign & FX at Ninety One, to talk all things emerging market debt.

Webster outlined the case for EM debt, highlighting the returns on offer for much less risk than used to be the case. 

Markets have moved significantly since then, amid changing interest rate expectations, so I reached out to Webster again to get an update on how he is viewing the opportunity in emerging markets, what impact those changing expectations are having, and how he and his team are positioning the portfolio right now. 

1. Last time we spoke, you were encouraged by the outlook for emerging market debt. How has it performed since then and what is the outlook now?

Since the end of 2023, emerging markets debt (EMD) has continued to perform. At the end of the year, EMD had outperformed Global and Developed market debt over 1-year, 3-years and 5-years. In 2023, EM Local Currency Debt returned 12%, Hard Currency Sovereign Debt returned 11% and Hard Currency Corporate Debt returned 9%.

As we approach the end of Q1 of 2024, yields have remained high, United States Treasury (UST) volume has peaked and rates are coming down, all of which has brought risk on fixed income back to the fore. The EMD asset class has continued to perform, with particular strength in hard currency debt (the EMBI has gained 1.9% YTD, driven by HY issuers (+4.1%).

Our outlook remains very positive on EMD and we have retained our overweight target. 

We are overweight EM hard currency debt, favouring high-yielding/Frontier names where spread compression and carry are particularly attractive. 

Although we believe we are past the peak in US yields, there remains a risk that the Fed may need to delay cuts on the back of the strong US economy.

In the EM local currency space, we retained our target overweight exposure, but trimmed it slightly post the Fed meeting. We still believe that EM rate-cutting cycles have further to go in select markets, supporting rates, but the sticky US inflation and strong economy makes deeper US rate cuts less likely. We continue to run an overweight in EM currencies, acknowledging strong underlying country fundamentals, high carry, and healthy external balances.

2. With interest rates seemingly having peaked (in the Western world at least), how will that impact the opportunity set moving forward – will this be as good as it gets in terms of returns?

The combination of a dovish Fed and improving global growth continues to be very supportive for EM and we believe EM has a lot more to give from here. 

Many EM economies have solid fundamental foundations. Many of the more fragile economies are receiving support from the IMF and other multilaterals.

Furthermore, with much of the painful interest-rate hiking now behind them, most EM economies are in an enviable position relative to developed markets overall, with most EM central banks either having completed their hiking cycle or beginning to cut rates. EM bond market valuations look attractive – with some markets still pricing in significantly more risk than we believe is justified, therefore a strong bottom-up approach to portfolio construction is key.

3. What geographies are you favouring right now—i.e. What have you been adding to the portfolio, and what have you been selling?

We are generally favouring high-yielding frontier names where spread compression and carry are particularly attractive. This is across geographies and is not isolated to a particular region.

We are generally underweight Asia across HC and FX, given expensive valuations in the HC space and negative interest rate differentials acting as headwinds to their currencies. On the Local Currency side we tend to favour Central Europe, where we believe there is room for inflation to surprise to the downside, leading to a more extended cutting cycle that is currently priced.

4. How else has the shape of the portfolio changed since we last spoke – can you give a couple of examples of investments you have made and why?

Although the overall top-down asset allocation has remained similar, we have moved to a modest overweight EMFX and increased our HC overweight. We are also now funding our EMFX overweight by being underweight euros (rather than the US dollar).

From a bottom-up perspective, we have been actively adding in a number of frontier markets across FX and HC. 

The theme here being attractive valuations with good idiosyncratic drivers. 

The current environment is favourable for long positions in frontier markets in both local and hard currency. These mostly idiosyncratic stories continue to benefit from the global monetary policy environment and stable-to-rising commodity prices. There has also been some improving fundamental stories in this space, examples include Egypt, Argentina, and Nigeria.

In Egypt: The IMF reached a staff level agreement, $8bn program alongside the EU’s €7.4bn funding, we also expect more funding from the World Bank. The recent devaluation of the Egyptian pound has also triggered significant investor interest.

In Argentina: We favour hard currency bonds. The Milei administration has prioritised the fiscal anchor and structural reforms. Fiscal adjustment continues, with strong numbers in both January and February. Milei’s extension of an olive branch to congress is a positive driver as he tries to get a deal with provincial governors to get his omnibus bill through. Argentina is also looking for a larger IMF deal, which will be supportive for credit.

In Nigeria: We like the local currency. The central bank has continued to tighten policy rates (hiked by 200bps at month end (27/03)). At the same time, the central bank has cleared the FX backlog, helping the currency. Although volatility remains, the picture looks more positive.

5. Last time we spoke, your big hairy prediction for markets was that the US won’t head into a recession this year – do you still stand by that (why or why not)?

We still stand by that - a full recession in the traditional sense does not seem to be on the cards. However, we will likely see a version of a recession within the next 4-6 months, but we believe this will be short and shallow.

6. What is your new prediction for markets (or simply the biggest thing you are debating right now)?

Global inflation and the Fed's cutting cycle remains the dominant topic of our top-down debate. The global inflation picture continues to be one of moderation overall.

Recent data releases have led us to become more confident of a soft landing (rather than a recession) for economies, especially the US. While financial markets are likely to remain volatile, we continue to be constructive on the medium-term outlook for returns from the EM debt asset class.