Dan Mottram: Good morning and welcome to the latest edition of the abrdn podcast series. Today we’re going to be discussing emerging market debt, taking a look at the review of the Q3 performance and then specifically diving into the outlook and some of the dominant themes that we think you should be looking out for. And with that, I’m joined by the Head of Emerging Markets at abrdn, Brett Diment. Good morning, Brett.
Brett Diment: Good morning, Dan.
Dan: Brett, thanks for joining us today. Always glad to hear your insights. So, I just really want to dive into things here and look at Q3, in particular. Q3 was a challenging period for almost all markets, but in particular fixed-income and rates had a pretty challenging time. And I think the increase that we saw in rates can be put down to what seems to be a pretty dominant theme for 2023, and that is the persistent inflation that we’ve seen – central banks globally trying to battle inflation – and that was, you know, made even harder this quarter by an increase in oil and some fears around food inflation. So, could you just talk to what you saw in Q3 and maybe just give us some thoughts about the increase in rates and what central banks have been doing?
Brett: Yeah, so I think from an EM perspective where we saw challenges, it was really a consequence of what was happening in developed markets, the US Treasury market in particular. So, if you look across EM credit, both sovereign and corporate credit, then actually where you saw the weaker returns, it was really investment grade credit. So, for example, if you look at the EMBI Global Diversified, which is the sovereign US dollar benchmark, so that was down 2% overall, but actually the investment grade component, so the component most linked to US government bonds highest rate was down 4%. In the corporate market, the SEMB, broadly the corporate market is down just .2% and actually the weakness was in the investment grade component down 1.3 and actually high yield was up. So, really where you saw the weakness coming through EM credit, it was more at the high-grade end. High yield did relatively okay across EM, we would argue a function of some of the better fundamentals.
In the local markets, we did see a bit of a drawdown in the quarter, so down about 3% in the local markets and that’s predominately a function of US dollar strength. I mean overall, in terms of where that leaves us for the year? So, modestly positive returns still for the EMBI Global Diversified, which is the US dollar sovereign benchmark, of about 2%; on the corporate just over three; and 4% on local currencies. So, still positive returns for the year as I admit a bit of a challenge via the US Treasuries for some of those higher rated bonds, in the closing phase of the year.
Dan: And then I guess, you know, outside of inflation, one of the other truly dominant themes, particularly for EM investors this year, has obviously been China. I think investors perhaps a little underwhelmed with either the growth coming out of China or, as a consequence of lower growth maybe, some of the expected stimulus that they thought that they would get in terms of support. So, how are you viewing China, some of those knock-on implications for your markets?
Brett: Yeah, I think generally we’re quite cautiously positioned on China across our EM, EMD strategies. So, underweight on local currency funds, you know, all the way to Chinese corporate credit and Chinese sovereign credit. We think growth is probably going to disappoint for quite some time within China. Obviously, we’ve seen a big deflating of what’s been the property bubble there. And certainly, if you look at other countries where historically they’ve seen a property bubble deflate like this – Japan is possibly a bit of a poster child for that in the late eighties, early nineties – typically you know, you do see a long period of subdued domestic growth. So, we think that’s going to be the case in China.
You know actually we think the rest of EM, that doesn’t necessarily have to be a negative for the rest of the emerging market debt. Certainly, there’ve been opportunities created by some of the geopolitical concerns around China. So, for example, FDIs have picked up quite markedly into Mexico and also some of China’s neighbors in Asia, for example, Indonesia.
And I think flipside, inflation’s clearly been driving these developed markets’ rates higher. Generally, in emerging markets inflation has been drawn down quite sharply and actually having quite subdued Chinese growth will also help on the margin to keep global inflation down. So, China’s certainly one to watch. But just given the breadth of opportunities we have in emerging markets, fixed income, really there are some very interesting stories across the space that we can invest in for our clients. And I think you’ve seen that on our strategies this year where despite that challenging background for China, you know, generally we’ve had some pretty good benchmark rates of returns across our EMD.
Dan: Yeah, definitely some interesting themes there. I mean, you’re touching on, I guess, nearshoring and friendshoring, which is something that investors have been talking to. And I guess one of the beneficiaries of that would also be India. India, I know is somewhere that you’ve been positive on for a while. So, could you maybe just talk to a reason that you are so positive and then for investors, obviously through the quarter, we saw the announcement that India would be making its way into some of the benchmarks and indices that you work within. So, maybe just explain that from the ground up and, I guess, what are the implications of that inclusion for investors?
Brett: Yeah. So, I think, you know, firstly in terms of India you’re right. You know, it’s been quite a longstanding overweight for our strategies, particularly on the currency side where we see bond yields around 8% and actually the currency, we feel, is quite well managed by the Reserve Bank of India. So, actually currency volatility is quite low against the US dollar. So, that’s an attractive investment for us, especially as we think inflation’s peaked. And as you rightly point out, Dan, one of the, from an EMD perspective, really interesting developments in the quarter was that JP Morgan – who run all the key emerging market debt indices – they announced that India would be joining their Local Currency Index.
Ultimately going to attempt Z weighting of that index. So, we think that will lead to additional capital inflows as India becomes quite a big weight in the Local Currency Index, you know, in the region of 20 to 30 billion USD most likely. And also India has interesting characteristics, it’s such a large domestic economy not too reliant on external trade for growth, then correlations between Indian fixed income and the broader market tend to be quite low so that will improve further the risk characteristics of the local currency markets – something that we, you know, we very much welcome and something we’ve been talking both to JP Morgan and the Indian authorities about for quite some time.
Dan: We talked some pretty large economies there in China and India. But as I look at 2023 and I guess one of the standouts for me has got to be frontier market performance and some of those smaller nations that you look at. You know, I think you touched on it earlier, the performance has been strong year-to-date, on an absolute and a relative basis. So, why is that? Can that continue as we go forward? For investors that aren’t invested in frontier, would you say they missed the boat or is there more left to come? How are you thinking about it?
Brett: So, you know, if we just look at frontier. So, frontier are smaller, sub-investment grade, emerging market countries. So, JP Morgan have an index called the NEXGEM Index. So, that was flat on the quarter, we’re talking about a very small 11 basis points positive return, on the year to date up almost 10%. So, probably one of the best performing fixed income asset classes out there. Yeah, I think some developments really happening there. First of all, some tier bonds were really trading at distress levels, 12 months ago the market really overpricing both default risk and for those distressed credits’ likely recovery values. So, you were starting off at some quite attractive valuations. And one of the challenges the market had last year was thinking about credits that were in distress – for example, Zambia and Ghana, both those countries were in default last year – was what would a workout look like? How long would it take? What would haircuts be like? We’ve made some good progress there. You know, China is a big creditor to Zambia in particular, also a creditor to Ghana, although to a lesser extent. And this seems to, having had a bit of a standoff between some of the Chinese lenders and institutions the IMF in particular, they are now working more closely together. And also, private sector bondholders, we are on the credits committees for some of those names, also working with the private sector creditors. So, we seem to be really moving ahead with those two debt restructurings. We would expect them to happen within the next six months or so, and ultimately with far smaller debt write downs than the market was expecting a year, 12 months ago. So, I think a combination of the attractive yield levels the market started for, the fact we’re moving ahead with these debt restructurings, and also the broad commodities outlook has actually been relatively positive for some of these countries. So, you know, you have pretty high oil prices, for example. You know, from here, we still think there are some really good opportunities in that space, potentially in local market space going forward and also, it’s really a part of the asset class where, you know, if investors have the resources to their own due diligence, you can really generate quite, quite strong total returns, if you do pick the right countries.
Dan: Certainly, an interesting area, the market for sure, maybe just to round out and close, I think, you know, we’d probably be remiss if we didn’t talk a little bit more in depth around the US economy and in particular the US dollar and the impacts for your asset class there.
I think, you know, if I’d personally been asking you questions at the start of the quarter, I would have been expecting a weaker dollar. But you know, we’ve seen a strengthening dollar over Q3. I’m not going to ask you to gauge the dollar exactly, but where do you think we’re at? What do you think the outlook is? How you how you think about it as you’re building portfolios?
Brett: So, from a portfolio point of view, one thing that we have done is we have reduced our emerging currency exposure. So, you know, we’ve hedged our exposures, we’ve had some exposures in South Africa. So, we think in the short term the dollar weakness we’ve seen could perhaps continue. However, starting to think that price action in the US fishing markets is evidence of opportunities. I mean, I’ve been investing in fixed income markets for 30 odd years and certainly to my mind, you know, US bond valuations two or three years ago, kind of sub 2, they were very stretched. Even earlier this year you had quite an inverted curve in the US. So, we’ve generally been quite underweight in the investment grade part of the market. Now getting towards 5% long dated US bonds, you’re perhaps getting towards more sensible longer-term valuations. Who knows, yields might go up a bit further. But you’re starting to see bond yields rise across a number of, especially the local markets in LatAm, in Latin America that, you know, we think valuation opportunities are really opening up here because actually there’s quite strong disinflationary trends across a number of Latin American countries. Central banks have been very proactive. So, we have actually been added to duration more recently. So, a bit more cautious on the FX, perhaps the dollar strength will last a bit longer. But certainly, from a rate perspective, you know, I think we could further out some of our interest rate positions over the coming weeks.
Dan: Great. And then last one. I mean, you mentioned LatAm. You know, I know another area that you’ve liked. Year-to-date, continues to be, you know, one of the areas that you like on a on a relative basis, would you say?
Brett: Yeah, there’s a lot of things with Latin America. I think the policy framework remains very orthodox in LatAm and quite surprising on the upside of Brazil, which is good for the fiscals. So, you know, kind of the core fundamental positives, let’s say, you know, but maybe in the short term we could see a bit more currency weakness. You know, until recently, the Mexican peso had appreciated, you know, getting on 15 plus percent year-to-date. We feel perhaps we can see a bit of sort of weakness, which is why we’ve got some of those hedges on. So, I’d say it’s more just protecting some of the gains that we’ve seen. We’ve got the currency hedges on, but certainly see the fundamental drivers still there in Latin America.
Dan: Well, thank you very much, as always, for taking the time to chat today. It’s always incredibly interesting chatting to you about what is a very interesting asset class. Thank you very much.
Brett: Great, thanks. Thanks, Dan.
Dan: And thank you to everyone online. You know, we are very well aware there are no shortages of podcast options for you to listen to, so we sincerely appreciate you taking the time to listen to us today. If you did enjoy it, please do check out the rest of all our podcast offerings at abrdn on your typical podcast provider. And if you do have any further questions, which either Brett or I can answer, please do get in touch with your local sales rep who will be able to connect you and we would be more than happy to chat again.
So, thanks very much for dialing in and we look forward to speaking with you next quarter.