Grant Webster

Conflict-related commodity market disruption is just the latest in a series of shocks testing policymakers and unsettling investors. Yet a familiar pattern is playing out in markets.

Grant Webster, Co-Head of EM Sovereign & FX: “Historically, EMs have borne the brunt of supply shocks, but in recent years resilience has become a more common theme. From the post-COVID energy/inflation shock to last year’s trade tariffs and now war in Iran, the initial EM sell-off has been brief and EM outperformance has ensued. At the same time, developed markets have faced rising yields and higher volatility, blurring^[1] the traditional distinction between EM and DM risk. Behind this lies relative strengthening in EM, with prudent fiscal policy, healthier current accounts and proactive central banks all boosting resilience. Investors and rating agencies are increasingly recognising these improvements, with the current EM upgrade cycle among the strongest seen in recent decades. Given this relative policy strength and higher real yields, we believe that EMs are better placed to withstand inflation headwinds.”

Looking ahead, the key question is whether renewed supply shocks could trigger another inflationary episode similar to 2022, when inflation peaked at around 8% in EM^[2] and 7% in DM.

Webster continued: “There will be winners and losers, but the backdrop is very different to 2022 when inflation forecasts had already risen sharply before Russia invaded Ukraine. Since February, EM inflation expectations have only increased by c.50bps and while a further rise is likely, high real rates across EM give central banks a lot more room to manoeuvre than their DM counterparts.”

That resilience is also visible at the corporate level, where many EM companies are used to operating with higher rates and inflation than their developed market peers.

Alan Siow, Co-Head of EM Corporate Debt: “Coupled with the strength of activity data we see across much of the EM universe, that means that EM economies should be better placed to deal with inflationary pressures arising from the supply shock vis-à-vis their DM counterparts.”

Broader lessons from the Middle East

The market reaction to war in Iran is also informative through a more regional lens. While Middle Eastern markets initially came under pressure, the reaction proved short-lived. Credit spreads have already fallen back to pre-war levels, credit ratings have been largely unscathed and bond issuance is continuing and receiving strong investor demand.

Victoria Harling, CIO – Middle East and Co-Head of EM Corporate Debt: “The resilience we’ve seen in Middle Eastern markets reflects a macroeconomic transformation: many economies have worked hard to reduce their reliance on oil exports and that’s really paying off.”

The region is also benefiting from efforts to position itself as a strategic commercial and financial hub in an increasingly multipolar world^[3]. Drawing parallels with the City of London in the early 2000s, Alan Siow “Authorities have made it abundantly clear that the region is open for business, and the number of global companies establishing a presence there is rising. At the same time, the region’s bond markets are becoming bigger, broader and deeper.”

Alongside economic reform, the region is also undergoing rapid social and cultural change. Archie Hart, Emerging Markets Equity Portfolio Manager: “From the vibrant social scene in an increasingly multicultural Saudi Arabia to plans for the region’s first casino in the UAE, the Middle East is changing and fast. Coupled with a raft of favourable characteristics – from time zone to connectivity – this is one of the most exciting regions for investors today.”

Energy market dynamics – a structural growth story for EM investors

While the oil price shock is a global challenge, energy market dynamics are also providing a rich EM-centric opportunity set for investors. Rising energy demand is coinciding with constrained and disrupted supply. Crucially, this is coinciding with a clean tech sector transformation. Solar modules, batteries and electric vehicles (EVs) have become the cheapest options available for EM economic and sustainable development, as China’s ambitious manufacturing and deployment rollout has pushed prices down at extraordinary speed.

Matt Christ, Emerging Market Transition Debt Portfolio Manager: “These improved economics have expanded the commercial opportunity set in EM and many of the associated investment opportunities reside in the private credit world. We’ve made deals across the energy value chain – wind power generation in the Philippines, energy transmission lines in Brazil, a renewable data centre provider in Latin America, and Egypt’s first sustainable aviation fuel production facility.”

Private deals in emerging markets also offer investors a favourable risk/return profile^[4], which contrasts with a loosening of underwriting standards in the US. Alper Kilic, Head of Alternative Credit: “Across EM, we’re seeing investment opportunities that tick multiple boxes for investors: exposure to structural growth themes, attractive yields and strong deal protections – on loans to fundamentally strong borrowers.”

AI – a disruptor and enabler

The examples above help explain how the EM private credit opportunity set is inherently heavy-asset, low-obsolescence (HALO).

Kilic noted: “These capital-intensive, physically irreplaceable assets contrast with the asset-light, software services business models that are increasingly prevalent in the US private credit market and appear most exposed to risks from AI disruption.”

In EM equities, too, there are compelling comparisons to be made with the US around AI.

The AI boom increasingly depends on hardware. A small group of EM firms sit at the physical limits of that infrastructure; the “Secret Seven”^[5] may represent one of the most overlooked opportunities in global equities today.

“Against a backdrop of a global shortage of chips, AI-driven memory demand is creating an enduring tailwind for South Korea’s Samsung Electronics. SK hynix is another Korean firm benefiting from the memory upcycle underpinning AI infrastructure spend. Elsewhere, a number of companies are well-placed in the context of Taiwan’s AI-export complex and data centre supply chain demand. Some of these businesses trade at multiples that are just a fraction of the lofty valuations seen in the US today,” said Hart.

Meanwhile, CATL is an example of a listed Chinese company with a true global edge: its EV Qilin battery supports a 1,000 km driving range on a single charge. The pace of AI development in the physical economy in China is also accelerating rapidly, including advances in autonomous humanoid robotics, as evidenced by a robot breaking the human half-marathon record.

Hart: “There are increasing parallels with the dotcom bubble, when EM equity valuations remained relatively low while parts of the US stock market overheated. The years that followed saw strong EM outperformance after the bubble burst. Today, we see similar dynamics emerging, making this the most compelling entry point for EM equities I’ve seen in 25 years.”

Reasons to recalibrate investment views

From a more structural perspective, even as resilience strengthens the risk profile of EM assets, an enduring premium remains.  Siow: “While the EM corporate credit universe is highly diverse and it’s vital to take a selective investment approach, the overall compensation for risk is generous. Across the EM universe, country-specific concerns often overshadow a company’s underlying fundamental strength, pushing yields above those offered by DM bonds of a similar credit quality.”

This phenomenon extends to the private market space.

“In the EM private credit world, the reason for the favourable risk/return profile is an enduring barrier to entry. The inherent complexity of these markets and the years required to build local expertise and origination networks mean competition remains limited, and the premium shows little sign of eroding,” said Kilic.

Taking a wider lens, with Hungarian 10-year government bond yields now within around 75bps of their UK equivalents, there is a strengthening case for taking a more holistic view of global investment allocations.

Jaspal Boparai, Co-Head of UK Institutional: “With supply shocks becoming the new norm, traditional asset class behaviour shifting and old EM/DM distinctions breaking down, investors must rethink how they build resilience and diversification in their portfolios while positioning themselves for a transforming world.”

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Notes:
[1] https://ninetyone.com/en/insights/reframing-fixed-income-the-old-rules-are-no-longer-fixed
[2] Ninety One estimates exclude India (incomplete data set), Turkey (extreme values).
[3] https://ninetyone.com/en/insights/the-end-of-easy-globalisation
[4] https://ninetyone.com/en/insights/private-debt-hidden-strengths-in-emerging-markets
[5] https://ninetyone.com/en/insights/the-secret-seven-undervalued-firms-at-the-heart-of-ai-infrastructure

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Grant Webster

Ninety One’s, Grant Webster, Co-head of emerging market sovereign & FX discusses the compelling reasons why Australian investors should be considering a standalone allocation into Emerging Market (EM) debt. Compared to many other developed markets, he believes Australian investors can find themselves in an advantageous position to be able to unlock returns from EMs more efficiently.

In a landscape marked with increasingly divergent monetary and fiscal policy, the diversification properties of EM debt allocation have risen in importance.

Webster notes, “Emerging markets exhibit resilient fundamentals and proactive policymaking, setting them apart in the current economic landscape.

“Today, emerging markets are approximately 15 per cent through their cutting cycles on average, significantly ahead of their developed market counterparts.

Despite these positive developments, current valuations in EM debt remain attractive, offering an attractive entry point and significant yield pick-up relative to domestic Australian fixed income.

“Australian investors are well-positioned in the EM debt landscape, benefiting from the Australian dollar’s natural hedge and the potential to enhance risk-adjusted returns through hedging strategies.”

Furthermore, many emerging economies have successfully rebalanced post the Global Financial Crisis (GFC), boasting impressive debt-to-GDP ratios and other vital metrics.

Webster concludes, “The opportunities within EM debt are evident, recognising the ability to diversify portfolios and capture attractive returns amidst the evolving global market dynamics.”

Read the whitepaper.

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Grant Webster

A disappointing decade in some areas of the asset class has left asset allocators questioning the investment case for EM debt. Grant Webster, Ninety One Co-Head of Emerging Market Sovereign & FX, provides an analysis of two contrasting decades and suggests that asset allocators should not dismiss the asset class.

While emerging market (EM) fixed income has proven its worth in long-term investors’ portfolios over the past 20 years – delivering outcomes comparable to those from developed markets (DM) – behind this lie two starkly different decades. Between 2003 and 2013, EMs materially outperformed to deliver compelling returns. This caught the attention of asset allocators, many of whom then entered the EM debt asset class with lofty return expectations, attracted by high revenue growth and resilient margins seen among quality companies in countries that were quickly building wealth. But over the subsequent decade (2013-2023) parts of the asset class have generated lacklustre returns. This has left some investors questioning the role of EM beta in portfolios.

In each of the past two decades, the US dollar has been a dominant driver of EM local currency debt returns. Between 2003 and 2013, the US dollar weakened by over 20% relative to EMFX, providing a boost to EM local debt returns. On the flipside, the most recent decade has seen the US dollar strengthen by almost 30%, weighing heavily on EMFX and the overall returns delivered by the EM local currency bond investable universe. Weakness in EM spot rates against the strong dollar took a particularly heavy toll during the taper tantrum years (2013-16) and then again in the COVID crisis (2020).

While US dollar strength played an outsized role in EM (local currency) debt performance over the past decade, it’s also important to acknowledge the role of economic vulnerabilities within EM. These developed in the five years post the GFC, coming centre stage in the taper-tantrum period. Large current account deficits financed by loose global liquidity, together with hot portfolio flows and weaker fiscal balances, also contributed weakness in EM debt in those subsequent years. Crucially, though, this precipitated a significant rebalancing of EM economies, laying a foundation of resilience, as we explore more below.

If we decompose asset class returns over the past two decades, we see that income has been the primary long-term driver. This is one of the reasons we are optimistic over the outlook.

Here are the three key considerations we think matter for investors assessing the prospects for the asset class.

First, EM Fundamentals are improving and – based on our measures of credit vulnerability – are at the strongest levels since 2014. Fiscal strength is seeing the biggest improvement, with increasingly healthy primary fiscal balances across EM. Funding strength is better than the pre-2012 period given growth in local funding markets, and external resilience is improving post-COVID on stronger basic balances (current account + FDI). While headline economic growth is being weighed down by growth and inflation volatility, the structural growth premium of EM above DM remains intact and above its long-term average, even though it is not back at the very high levels seen in the first decade we consider in this report. All of this points to EMs being in a good position structurally.

Secondly, looking across a suite of valuation metrics, the dollar looks over-valued. Although it has moved off its recent highs, it remains at levels last seen in the early 2000s. While we are not advocating for a significant sell-off in the US dollar – or, conversely, an EMFX bull run – this headwind to EM local currency bonds looks less challenging than over the prior decade, making it likely that compelling carry can resume its role as key driver of returns.

Finally, turning to valuations, the spread pickup relative to DM remains appealing. While spreads are below historical highs this is expected, given the relative resilience of EM fundamentals. The recent rise in EMBI yields looks not dissimilar to the 2008-2009 experience, while many local currency yields are still close to post-GFC highs. Given yields have historically been a reliable indicator of forward-looking returns, current valuations support the case for EM debt, particularly in light of the stronger EM fundamentals currently witnessed.

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