Active Thinking: Can EM debt step out of the Dollar’s shadow in 2024?

Following a tough 2022, emerging market debt has fared well so far in 2023, outperforming US government bonds and investment grade credit, particularly as some softer US data weighed on the dollar. Paul McNamara, Investment Director and lead manager on emerging market debt strategies, analyses the key factors affecting the asset class and shares his thoughts on what to look out for in 2024.

24 November 2023

Recent months have been characterised by some slowdown in global economic growth, as well as the inevitable geopolitical factors. As ever, the outlook for the US economy has been uppermost in investors’ minds. Significantly, having defied most expectations even as US interest rates hit their highest level in 22 years, signs are emerging that the US economy could finally be heading for some kind of ‘landing’. Whether it will be soft or rather bumpier remains to be seen.

Following the peak stimulus of ‘Bidenomics’, including major personal and business tax breaks, cracks could at last be forming in the runaway labour market, with wage growth slowing and jobless claims creeping up. In keeping with our long-held belief that developments in credit drive the economic cycle, we are monitoring US financial conditions and credit standards as closely as ever. In particular, we are vigilant to the risk that new borrowing – presently high, but not matching the highs that preceded previous downturns, could soon flag recession risks. We also analyse the Federal Reserve’s (Fed) Senior Loan Officers’ Survey in some detail – this has suggested that the credit impulse could weaken further, and that demand growth could contract.

So much for the US economy slowing. Of course the European economies have not exactly been firing on all cylinders, but overall the economic picture there remains fairly solid. Even with the European banking sector in good shape, there has been some tightening of credit conditions across the Euro area, and new borrowing has declined, but growth figures have thus far proved more resilient than the credit data would suggest. Europe is by no means out of the woods but there are clear signs that the economy is hanging in there.

Mind the growth gap – US vs rest of the world

In the event that we do have a global recession, there is no doubt that emerging markets (EM), as a growth asset class, would be impacted by negative sentiment. But, for EM debt to shine, what we really need is for the economic growth gap between the US and other regions, notably Europe, to narrow. And in the last month or so, we have seen hints that this scenario could be in the very early stages of playing out. US inflation data has started to come into line and the Fed has begun to dial down the hawkish rhetoric, with the huge gap in growth and the gulf in interest rates between the US and Europe effectively moving against the USD. And in a matter of those few weeks, local EM debt benchmarks have returned in the region of 4%, emphasising how a softer USD adds to the return prospects for this asset class.

At present, we favour the countries with high rates, where real interest rates are high, certainly relative to where they have been in the past. We like Mexico, Brazil and Indonesia, although the latter does not tick that box convincingly and instead benefits from other factors. Generally speaking, inflation has come down much faster in EM than it has in the rest of the world.

And bond markets of Mexico and Brazil have actually outperformed the US; year-to-date local EM bonds are c 4% ahead of US Treasuries (mainly due to the weaker USD), ahead of US high yield debt and hard currency sovereigns. But generally, a combination of high rates and falling inflation is the magic formula for local EM bond strategies, pretty much as it is for any other bond strategy.

EM politics: more noise than economics

Clearly, geopolitics will play a role in the appeal of EM debt over the next year. For example, any significant escalation of the present Middle East conflict could see a knee-jerk spike in the USD, given its traditional ‘safe haven’ role. EM-specific politics could also have some bearing, albeit that EM politics tend to be 80% noise and 20% economics. The best example in recent years has been Poland; the previous government came into office on an agenda of sweeping economic measures but actually delivered on few of them, and has since steered towards a more orthodox path. And talking of EM politics, Argentina is in the spotlight at the moment following Javier Milei’s victory at the presidential elections. Milei is an economist and animated TV pundit by trade but also a real political maverick and right-leaning libertarian, the like of whom we have never seen before. He comes into office on the back of a truly radical policy agenda, including ditching the peso in favour of the USD, shuttering the central bank and slashing government spending. While Milei’s proposed policies have found favour with the electorate, particularly young voters frustrated with poor employment prospects and hyperinflation (annual inflation hit a nosebleed 143% in October), we take the view that the scale of policy change actually implemented will be much lower than many currently anticipate. In any case, at present Argentina is uninvestigable as a market, in our view, although investors will be following developments with keen interest. In the bigger picture, Javier Milei is not the first EM country leader to be elected on promises of a new political and economic era. But, based on what we have witnessed time and time again elsewhere, the reality of what is actually implemented is likely to disappoint some of his most fervent supporters. While there has been no shortage of bad news relative to Argentina, it is fair to say that much of it is already reflected in valuations, so we will monitor developments with keen interest.

China remains an important sentiment bellwether for EMs

Another key talking point for EM investors of all persuasions is China. Clearly, anyone thinking of raising their allocation to local or hard currency EM debt would want assurance that the challenges China faces will not lead to any kind of full-blown crisis that would damage sentiment towards wider EM assets. Nobody is disputing that China has huge problems, including major structural challenges and a troubled real estate sector. But from a short-term or even a medium-term point of view, the relationship between Chinese credit growth and Chinese GDP growth is unbroken. As long as credit growth (and that can be credit growth driven by the central government, or driven by the private sector encouraged by the central government), the economy keeps on motoring.

If credit is growing strongly in China, then GDP growth will also be strong in China. And at the moment, Chinese credit growth is extremely strong. What people further out in the medium term are concerned about is that losses on credit extended within China could one day precipitate a breakdown of the lending process, to the extent that the government loses control as a means of pushing credit out and into the system. We are absolutely open to that as a future possibility, and a risk to factor in. But what we can is say that it is not happening at the moment. In fact, Chinese growth is doing just fine and as long as that is the case, that can act as a positive backdrop for other EM regions, especially for South America.

All in all, we expect G10 growth to slow further, global labour market pressures to ease, and for the inflation outlook to improve. And in EMs specifically, we expect the ongoing moderation in food prices to extend the sharp fall we have been seeing in EM inflation. And, should conditions fall into place for the US economy to lose some of its glow relative to other parts of the world into 2024, then EM debt should be well-placed to step out from the dollar’s shadow.