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Trends Watch: Emerging Markets Fixed Income and Currency

Jul 28, 2022

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.  

This week, Elana talks with Scott Grimberg, Head of Emerging Market Debt, Itau USA Asset Management. 

What is your outlook for investing in emerging markets fixed income and currency?

While my longer-term outlook for emerging market (EM) fixed income and currency is generally positive for a variety of demographic, growth, and leverage reasons, the short- and medium-term environment is quite challenged. The external (non-EM) environment is facing two major issues: slowing growth in China and rising U.S. (and developed market [DM]) interest rates. This means that the yields (actual and implied) must rise, not only to keep pace with yields in the “funding” currencies (especially USD) but that the “premium” (e.g., spreads) must also rise to compensate for the volatility and risk. So EM assets are under pressure along with the rest of the universe of “risk” assets. Over the medium term, we expect that stimulus in China, especially fiscal stimulus and infrastructure development, as well as more clarity on U.S. interest rates, will allow for a stabilization for EM asset markets and much-improved returns. Longer-term, we expect that the demographics, lower leverage and higher growth of EM versus DM will necessitate asset flows from the developed world to the emerging world in order to capture higher premiums and returns not available in the developed world’s asset markets. In the past 25 years, EM (including China) has tripled its share of Global GDP and trade while, at the same time, represented the same percentage of global capital markets (around 11%) that they did 25 years ago. We especially note that EM markets are, for the most part, much lower levered (e.g. (Equity+Debt)/GDP) than the developed world (with a few notable exceptions, such as China and Brazil) which will allow, under the right conditions, the maintenance of higher growth rates over the long term. Further, this relative underleverage also means that EM will be able to expand their public and private asset markets at a faster pace than the developed markets for many years.

What are the greatest opportunities you see and why?

Commodity exporting countries (especially those in the Middle East and Latin America), countries with current account surpluses and companies that have strong cash flows as funding costs rise. As we leave the era of ultra-low interest rates, countries and companies less dependent on external financing and having low debt-carry costs will be able to not only weather the tighter funding, but also take advantage of better liquidity positions to support domestic growth (countries) or gain market share (companies). So besides riding the wave of commodity exporters and issuers that can take advantage of the commodity price shock, investors need to identify those places (countries, companies, etc.) that will be able to take advantage from the global shuffle in supply chains. The last two years have taught us (and the corporate world) that a reliance on a narrow or single source in the supply chains leaves us (them) vulnerable to sudden shocks and stops. Further, as foreign investors face additional obstacles to investing in China, there is going to be demand for different, or at least alternative, sources along the supply chains. EM professionals are well versed in identifying the policies and balance sheets that allow countries to attract both foreign direct investor and portfolio investment. This will be a source of long-term outperformance and returns for EM investors.

What are the greatest challenges you face and why?

We are coming off a multi-year, mega-liquidity cycle that has allowed ALL risk assets to perform well. The difference between “good” and “bad” country and corporate policies has been minimized by the abundance of liquidity. Investors are now going to have to adjust to a world of scarce liquidity, which means higher premiums and a larger gap in returns between the “good” and the “bad.” This will force investment professionals, especially in EM, to look further than a “bounce” from a sell-off (or rally). Most importantly, investment professionals will need to guide portfolios (and clients) to the potential for longer-term returns.

What keeps you up at night?

What keeps me up at night is that, in the 30 years that I have been investing, I have not seen a Federal Reserve tightening cycle that hasn’t led to some kind of liquidity or, worse, credit crisis. By nature, these crises come from sectors that are not only underinvested, but also tend to hide their volatility and risks (bubbles are usually identified in hindsight). I suspect that the past few years of monetary stimulus has resulted in a bubble in global government bonds, particularly in the developed markets. In retrospect, negative real yields were not really sustainable and, worse, negative nominal yields appear even more extreme. Right now, investors have been deflating the bubble in nominal yields, forcing them back into positive territory, but real yields (observed but not implied by Treasury Inflation-Protected Securities) remain in negative territory. The impact of negative yields (real and nominal) was an explosion in debt issuance (public and private), especially in the developed markets (though EM issuers have certainly been active as well). Whether this is a bubble that will lead to a crisis, I do not know, but I suspect that ultra-low yields have been hiding some serious credit problems. Worse, governments can ill afford politically for inflation to erase the real value of the debt, so they will have to find some way to reduce debt, pay it down or otherwise service their debt loads.

I am also quite concerned about frontier markets, which are teetering between unsustainable debt loads and sharply rising prices for food and fuel. I question how frontier countries, which are dependent on food and energy imports, can maintain political and economic stability in the next 18-24 months unless some significant event occurs, such as a drop in food prices or an infusion of large-scale multi-lateral financial support. I am concerned that many of the lower-income countries could experience gradual political and governance unraveling while the more authoritarian ones could conceivably collapse (as we saw in the Arab Spring).

The views and opinions expressed above are of the interviewee only, and do not/are not intended to reflect the views of EisnerAmper.

The views expressed below are those of Scott Grimberg, Head of Emerging Market Debt at Itaú USA Asset Management, Inc., and do not necessarily reflect or represent the views or position held by Itau USA Asset Management, Inc. or its parent company.

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Elana Margulies-Snyderman

Elana Margulies-Snyderman is an investment industry reporter and writer who develops articles, opinion pieces and original research designed to help illuminate the most challenging issues confronting fund managers and executives.

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