MFS IM: Emerging markets under Trump 2.0: debt with potential
This article was originally written in Dutch. This is an English translation.
In an increasingly unpredictable world, emerging market debt can be an attractive haven for investors. It offers diversification, reduced exposure to developed economies and opportunities for returns.
By Neeraj Arora, Portfolio Manager Fixed Income, MFS Investment Management
Until recently, the global economy appeared surprisingly resilient. Growth remained stable, inflation fell gradually – allowing room for interest rate cuts – and even the Chinese economy picked up. However, the recent increase in US import tariffs has undermined this relatively favourable starting position. The extent of the impact will depend mainly on the scope and duration of these measures.
Emerging countries – with the exception of China – are likely to play the diplomatic card first before responding with import tariffs of their own. The most likely response is a combination of interest rate cuts and additional government spending to support the domestic economy. As a result, the US economy could weaken, putting pressure on the dollar. This combination of slower growth and policy uncertainty could prompt investors to withdraw their money from the US and invest elsewhere – a trend that could cause the dollar to weaken further. And a weaker dollar is generally good news for assets in emerging markets.
Strong fundamentals
Although a tougher US trade policy may seem threatening at first glance, its impact on emerging market creditworthiness is likely to be limited. Yes, risk premiums will rise in a global slowdown – but that applies to all credit markets.
However, many emerging countries have sufficient policy scope to soften the blow to their economies: through interest rate cuts, targeted government stimulus or a controlled weakening of their currencies if necessary.
Moreover, it is worth remembering that during President Trump's first term in office – despite his America First policy – returns on emerging market debt (EMD) were particularly strong. Also important: historically, these markets tend to perform well in the years following an initial interest rate cut by the US central bank (the Fed). Add to this the current high initial yields, and the outlook for total returns over the medium term looks quite favourable.
Healthy foundations
Despite geopolitical tensions and economic uncertainty, the underlying fundamentals of emerging markets are robust. External positions are healthy: as a group, these countries have a positive “basic balance” – the sum of their current account and direct foreign investments – and they have ample foreign currency reserves.
In addition, the share of their debt denominated in foreign currencies is relatively low. This makes these countries less vulnerable to an expensive dollar or rising international interest rates. Most emerging countries have flexible exchange rates, which helps to absorb external shocks. A slight depreciation of their own currency can also help to mitigate the effect of trade barriers.
There are also positive developments on the fiscal front: many countries are actively working to reduce their primary deficits (budget deficits excluding interest payments), which will help to stabilise public debt in the long term.
Choosing is crucial
But where can investors find the most value in the very broad universe of emerging markets? The best bet is to focus on countries with strong macroeconomic fundamentals, such as Chile and Poland. Economies with these characteristics are generally more resilient to global shocks.
Also interesting are countries that are putting their external balances in order and implementing reforms to improve economic growth. These countries, which currently often have a BB credit rating, will therefore be able to continue to grow in the long term and be upgraded to investment grade. Examples include Costa Rica, the Dominican Republic and Paraguay in Latin America. In Europe, Serbia is a good example of a country that is improving its balance sheet and implementing reforms. In North Africa, Morocco is a positive example.
Despite geopolitical tensions and economic uncertainty, the underlying fundamentals of emerging markets remain robust.
In addition, sustainability is playing an increasingly important role. When integrating ESG criteria into the selection process, countries such as Costa Rica, Chile and Morocco are showing clear progress in this area.
Corporate bonds from emerging markets offer additional diversification and can enhance returns. Careful selection is essential here: preference is given to companies with healthy and improving credit characteristics, preferably in defensive sectors or companies focused on exports in stable countries such as Chile, Mexico, Poland, Indonesia and India. As always in emerging economies, good diversification across sectors and regions remains essential.
Local currency bonds also offer opportunities. The most attractive ones can be found in countries with high interest rates, cooling inflation and room for monetary easing, such as the Czech Republic, Poland, India and Mexico. Investors can also decide to hedge the currency risk if they have less confidence in the currency, thereby focusing entirely on the underlying bonds.
Time for reconsideration
Belief in “American exceptionalism” as an important theme in the markets is waning, and this could have major consequences for the global allocation of capital. During Trump 1.0, it briefly seemed that emerging markets would fall out of favour, but reality proved otherwise and returns were good. Now, too, these markets seem ready for a comeback.
EMD offers investors diversification because it has a relatively low correlation with US and European government bonds. If the dollar weakens, as is to be expected with further interest rate cuts by the Fed, emerging market currencies could strengthen, further increasing the total return.
Admittedly, valuations on global bond markets are not low, not even in emerging markets. But the range of products in this segment is broad and the differences between countries are large. That is precisely why active management, careful selection and diversification are making the difference at the moment.
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SUMMARY In a volatile world, emerging market debt is an attractive haven for investors. During Trump 1.0, returns on EMD were particularly strong – despite his America First policy. Although a stricter US trade policy appears threatening at first glance, the impact on emerging market creditworthiness is likely to be limited. EMD offers diversification because it has a relatively low correlation with US and European government bonds. |