Exceptionally powerful and competing economic forces are radically reshaping the landscape for emerging market (EM) investors. But for those with analytical capabilities, the resulting divergence in country and asset performance makes this fertile ground on which to generate returns.
The global macroeconomic environment is exceptionally uncertain. On the one hand, the Covid-19 pandemic keeps delivering ugly surprises; the exceptionally infectious Delta variant is the latest but unlikely to be the last. On the other, global central bank liquidity remains generous, as do fiscal stimulus measures. Inflationary pressures are growing – some are temporary, others could well take hold. Governments are under pressure to respond. Elsewhere, particularly China, there appear to be secular political shifts.
All of which further muddies an already complicated picture – there is huge variation among emerging market economies. Spanning the full spectrum of economic activity, from raw commodities to finished high end manufactured goods, emerging nations are expanding at varying speeds. At the same time, there’s significant differentiation in the assets on offer even within those countries.
So, in some cases, when a country’s dollar-denominated bonds are richly-priced, it is its local currency bonds that offer the prospect of better attractive risk-adjusted returns.
At the same time, the growing popularity of green bonds among sovereign issuers adds a further dimension to an investor’s decision making.
Varying impacts of Covid, varying amounts of stimulus, big divergences in country fundamentals, the introduction of green bonds on top of locally and hard currency-denominated securities all make navigating this EM bonds a challenge that demands expertise and experience.
Covid
The single most important issue facing all countries, but particularly emerging economies given their relatively limited public sector and financial resources, is how hard they were hit by Covid-19 and how effective their responses have been.
Countries’ relative performance, or their ‘pandemic trajectory’ is a key determinant of how their economies and markets are likely to shape up – and not just over the short term. There is also the longer-term threat from what economists call hysteresis, or the economic and social scars Covid leaves behind.
These effects will in part be determined by countries’ ability to contain the epidemic. That’s to say case, morbidity and mortality counts. These, in turn, will have been affected by the degree to which public health services have come under strain. These countries’ prospects will then be further influenced by the pace at which they are managing to vaccinate their populations (see Fig. 1). Countries that escaped the worst of the pandemic during 2020 and 2021 but have very low vaccination rates could still succumb to new strains of the virus, such as the Delta variant that swept through India during the spring and has since spread widely.
Commodities
With the recovery has come a boom in commodities, not least oil. Though generally prices have pulled back from their highs amid signs of a Chinese slowdown, the overall trend has been positive this year. Some of this strength has been a result of rising demand as life gets back to normal, partly stemming from bottlenecks in the supply chain caused by lingering after-effects of pandemic lockdowns. And emerging economies reacted differently to the revival in markets for raw goods.
Many commodity exporters were buoyed by improvements in their terms of trade. Markets welcomed the turnaround. Take South Africa – the country moved from running a current account deficit to a surplus as exports improved, which, in turn, boosted the rand. Elsewhere, however, an improving trade position was offset by other risks, such as political upheaval in the case of Peru and Colombia or geopolitical stresses (here South Africa is also at risk given febrile conditions in the streets).
On the flip side, large commodity importers such as China, have been hit by higher raw material prices. This has had the effect of pushing up inflationary pressures, particularly in Central and Eastern Europe, or of weakening their current account positions, and thus raising external funding costs.
Social shifts
How emerging countries compare in terms of their performance on environmental, social and governance (ESG) matters is also bound to affect their investment appeal. Social and governance factors are particularly important in parts of Latin America, where leftist politics and populism are witnessing a resurgence. This raises the risk that these countries will suffer an erosion of their long-term creditworthiness as politicians attempt to spend their way out of problems, causing fiscal pressures to mount. At the same time, worsening youth unemployment, poverty and educational outcomes are a threat to countries’ human capital formation, with Latin America again particularly at risk.
Monetary policy
Inflation is a big question for investors everywhere – but especially so in EM. Huge flows of global liquidity and substantial measures of fiscal policy have kick-started economies in the wake of the pandemic. Further waves of mass infection could yet prove a damper on both growth and price pressures. But as countries learn to cope with Covid, the existing stimulus could cause economic growth to boil over.
So far, EM central banks have taken an aggressive approach as inflation breached their targets – by and large they’ve been well ahead of developed economies in tightening policy (see Fig. 3). As a result, we think the markets have more than fully priced in the degree to which rates will be hiked by the time they peak. For instance, we think too much has been priced in for Russia, Mexico and Colombia, presenting us with attractive opportunities in those markets.
But even here there is considerable differentiation between emerging economies. For instance, inflation remains quiescent in emerging Asian economies so central banks there are likely to maintain dovish policies, especially in light of their rising infection numbers.
Making the most of differentiation
Investors in emerging markets have their work cut out. Countries face more complex challenges than ever, many of them brought to the fore by the Covid pandemic. It has compounded the impact of differing degrees of development and differing access to resources, be they natural or man-made and ranging from infrastructure to human capital to strength of institutions. And it has added another dimension to domestic politics.
Pictet Asset Management has a multi-faceted investment approach, using expertise from across the firm, that weighs up macro, political, environmental and social dimensions.
Take our approach to investing in Chile. We see limited value in Chilean 10-year dollar-denominated debt, which trades at a spread of just 99 basis points over US Treasuries, and so have an underweight position in this asset versus the benchmark across our portfolios. Where we do own the hard currency bonds, we express a preference for the country’s green bonds that trade in line with the conventional bonds. For bonds priced in Chilean pesos, our recent bias is to receive local rates, as we believe that the bonds’ recent weakness implies expectations for too many policy rate hikes. At the same time, we have a more strategic bias to be overweight the currency, as a recent bout of weakness presents an attractive entry point.
“Investors in emerging markets have their work cut out”.
As a team, we have learned to pay greater attention to the risks and opportunities presented by environmental matters and transition risk.
We think green bonds are a good way for governments to finance climate change initiatives and consequently encouraged Hungary to start a green bond programme that we could participate in at the time of issuance. Romania has been less quick to adapt these measures, but here too we have been pushing the government to recognise demand for these instruments. Encouragingly, it has responded by developing a green bond framework which should help build its sustainability-focused credentials.
We have a global reach, with a regional approach based around London, Singapore and New York, giving us local perspectives across the emerging market universe that we marry with our global macro and strategy strengths.
Opinion written by Mary-Therese Barton, Head of Emerging Market Debt at Pictet Asset Management.
Discover more about Pictet Asset Management’s long expertise in emerging markets.
This material is for distribution to professional investors only. However it is not intended for distribution to any person or entity who is a citizen or resident of any locality, state, country or other jurisdiction where such distribution, publication, or use would be contrary to law or regulation.
The information and data presented in this document are not to be considered as an offer or sollicitation to buy, sell or subscribe to any securities or financial instruments or services.
Information used in the preparation of this document is based upon sources believed to be reliable, but no representation or warranty is given as to the accuracy or completeness of those sources. Any opinion, estimate or forecast may be changed at any time without prior warning. Investors should read the prospectus or offering memorandum before investing in any Pictet managed funds. Tax treatment depends on the individual circumstances of each investor and may be subject to change in the future. Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested.
This document has been issued in Switzerland by Pictet Asset Management SA and in the rest of the world by Pictet Asset Management (Europe) SA, and may not be reproduced or distributed, either in part or in full, without their prior authorisation.
For US investors, Shares sold in the United States or to US Persons will only be sold in private placements to accredited investors pursuant to exemptions from SEC registration under the Section 4(2) and Regulation D private placement exemptions under the 1933 Act and qualified clients as defined under the 1940 Act. The Shares of the Pictet funds have not been registered under the 1933 Act and may not, except in transactions which do not violate United States securities laws, be directly or indirectly offered or sold in the United States or to any US Person. The Management Fund Companies of the Pictet Group will not be registered under the 1940 Act.
Pictet Asset Management (USA) Corp (“Pictet AM USA Corp”) is responsible for effecting solicitation in the United States to promote the portfolio management services of Pictet Asset Management Limited (“Pictet AM Ltd”), Pictet Asset Management (Singapore) Pte Ltd (“PAM S”) and Pictet Asset Management SA (“Pictet AM SA”). Pictet AM (USA) Corp is registered as an SEC Investment Adviser and its activities are conducted in full compliance with SEC rules applicable to the marketing of affiliate entities as prescribed in the Adviser Act of 1940 ref.17CFR275.206(4)-3.
Pictet Asset Management Inc. (Pictet AM Inc) is responsible for effecting solicitation in Canada to promote the portfolio management services of Pictet Asset Management Limited (Pictet AM Ltd) and Pictet Asset Management SA (Pictet AM SA).
In Canada Pictet AM Inc is registered as Portfolio Manager authorized to conduct marketing activities on behalf of Pictet AM Ltd and Pictet AM SA.