Emerging market debt

The result of this sea-change is that governments are unlikely to return to austerity – at least not until they’re forced to do so by the markets. Instead, governments will try to keep their debt burdens in check by growing their economies. Increased but targeted government spending will drive higher capital expenditure and demand for resources – both of which are likely to benefit commodity producers. The downside is that higher interest rates will predominate.

What’s less clear is how this fiscal largesse will affect international capital flows. Highly indebted governments will adopt a new style of financial repression. They will seek to unlock domestic capital – much of which is currently invested abroad, disproportionately in the US – via tax incentives, legislation and marketing (see Fig. 1). This could well prompt a reversal of the money flows that have until now underpinned US asset price outperformance and, ultimately, US dollar strength. Should this occur, it would ultimately be most transformative for asset prices in emerging markets – developing economies stand to benefit from the combination of resurgent investment and capital spending.

Not only that, but they are now less vulnerable to investor flight. In 2008, 81 per cent of emerging market sovereign and corporate debt was issued externally in foreign currency, predominantly dollars.  By 2023 that proportion had dropped to 44 per cent. The majority of emerging market sovereign debt is now financed domestically, in local currency. 

That’s down to the increasing maturity of these economies – there are more domestic savers who now have increasingly sophisticated domestic capital markets in which to invest their money. This maturity is, in turn, a product of economic growth and the discipline imposed on governments by independent central banks, by floating exchange rate regimes, by fiscal rules, by the creation of public and private pension systems and by ever more solid domestic institutions. This is particularly true in countries that in the past had been prone to crises.

The pandemic forced Western governments to recognise how
much of their supply chains were tied to China. That coincided with a
realisation of how powerful China had become militarily as well as
economically. The drive by developed countries to reduce their
dependence on the country was a blessing to other emerging economies.
Some, like Latin America, have benefited from US near-shoring. At the
same time, Chinese firms have shifted some of their own production
abroad, particularly to South-East Asia, as a way of circumventing some
of the trade barriers that have sprung up.  

This has boosted capital flows to the rest of EM Asia, not just because
investment is no longer being crowded out by the capital-hungry regional giant, but also because increasingly rapid growth in these countries has created a deeper and broader middle class who are looking for places to put their savings (see Fig. 3).

Many of these countries are resource rich – they are the main source
of metals needed for the clean energy transition as well as strategic
minerals for military and technical applications. And demand is only set
to grow for these (see Fig. 4).

Perhaps their most important resource, however, isn’t mined or felled
– it’s their people. Many developed countries face ageing and shrinking
populations. That’s less of an issue in the emerging world – albeit
with some notable exceptions like South Korea and China (see Fig. 5).
This isn’t just cheap labour, but it represents the future of
consumption and of innovation as greater wealth feeds through to
education. Foreign firms have discovered this resource: Google, for
instance, doesn’t see India as a place to outsource low skilled jobs,
but is hiring across the pay spectrum, with a view to building services
to meet local needs.https://www.cnbc.com/2024/05/01/google-cuts-hundreds-of-core-workers-moves-jobs-to-india-mexico.html

For emerging economies to fully take advantage of capital flows, their
infrastructure needs to be built out – something their governments are
encouraging. Development banks are competing to invest in emerging
markets – for instance, the IMF in Latin America, World Bank and US
Treasury in West Africa, while Middle Eastern sovereign wealth funds are also being increasingly active. Collectively, these are helping to fund
investment while also providing an important backstop to sovereign
credit markets and thus reducing default risk.
 

At the same time, low foreign ownership of emerging market debt, particularly local currency debt, plus the fact that these currencies are significantly undervalued offers investors a good balance of reward for given risk. 

And emerging market bonds are an effective diversifier for portfolios. Emerging market fixed income exhibits low correlations to core fixed income asset classes – US treasury bonds and investment grade credit – but is also uncorrelated to US equities. At the same time, the sub-asset classes within emerging market bonds – hard currency sovereign, hard currency credit, local currency sovereign, local currency credit – are also relatively uncorrelated with each other, creating opportunities for diversification within an emerging market fixed income allocation.

Together, these factors offer investors an expanded opportunity set. Local currency debt, both sovereign and corporate, looks increasingly attractive thanks to the strong domestic investor bases. More generally, sovereign and corporate credit risk is reduced, particularly in the case of large, systemic countries and companies. This reduced reliance on the dollar, makes these assets less sensitive to US interest rates and less sensitive to external shocks. But crucial to navigating this new world order will be the  ability to dynamically allocate across the whole range of emerging market assets.