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After a challenging 2022, emerging market (EM) debt offers the potential for attractive yields and diversification in 2023, said many in the industry. With low growth across developed markets, investors are looking for return in the emerging markets sphere. However, recent changes – and what they mean for yield – should be carefully considered.
“Investment portfolios are under-allocated to [emerging market debt]”, said Kristin Ceva, Managing Director at asset manager Payden & Rygel. “Institutional portfolios [have] around 4% to 6% of their assets in EM debt”, she added. “Investors may wish to rethink their positioning in 2023.”
Ceva added that she believed EM debt offered especially attractive yields. As of the end of May 2023, EM sovereign yields were 8.6%, EM corporate yields were 7.5%, and EM local yields were 6.5%, she said. “Though with significant dispersion, several countries offer 8-12% local yields.”
“About 60% of the sovereign dollar-pay index is investment grade, and the percentage is even higher amongst emerging markets corporate bonds (67%)."
She also added that stereotypes around emerging markets – such as being a tricky place to do business – had lessened significantly post-pandemic. Many markets, she said, had sought to modernise, and EM debt “[wasn’t] as risky and underdeveloped as many investors believed [it to be]”.
“About 60% of the sovereign dollar-pay index is investment grade (IG), and the percentage is even higher amongst emerging markets corporate bonds (67%) and local currency bonds (75%),” Ceva continued.
These comments reflect the changing state of emerging markets themselves – not just investment opportunities – especially in Asia. Several new solvency regimes have taken shape across insurance sectors in numerous east Asian countries, which could allow for new local partners and signify that markets are becoming more stable for investors.
Rapid urbanisation and population growth have also affected appetites. In the last 20 years, the urbanisation of emerging markets – such as in China – has created enough wealth to more than double the ranks of the consuming class, to 2.4 billion people.
Annual consumption in emerging markets will rise to $30 trillion, up from $12 trillion in 2010. “It will soon account for nearly 50% of the world’s total consumption, which is up from 32% in 2010,” said Mark Martyrossian, Director and Head of Distribution at Aubrey Capital Management in a recent paper on the topic – “Why we focus on the Emerging Markets consumer”.
According to research from McKinsey, this number will have nearly doubled again to 4.2 billion consumers by 2025, said Martyrossian. This is especially noteworthy considering the global population size of 7.9 billion people, he added.
Recent conversations have honed in on China’s ups and downs – its staggering economic recovery post-Covid lockdowns, including the ongoing Evergrande affair, and the pressures on its middle class, which, coupled with the shrinking population, has seen more eyes turning to India, the world’s most populous country.
Investment manager Ninety One said in its new insight, “Hidden GEMs: India’s sleeping cat has become a roaring tiger”, that the country was developing its ability to deliver ‘hard’ infrastructure projects. This, it added, was one area investors could look to for growth opportunities.
“Highway construction, which averaged 28 kilometres per day in 2019/20, is targeted to reach 45 kilometres per day in 2023/24. The government is also addressing the historic inefficiency of India’s railways,” the analysis said.
A key project here is the Dedicated Freight Corridor (DFC), which is “an ambitious attempt to create new freight rail capacity in the heart of India”. The DFC has been under construction for several decades and is hoped to be completed by mid 2020s. If completed on time, it would “mark a break from the past, where India struggled to execute its infrastructure plans”, the insight said.
Ceva noted that she believed China’s slowdown would impact other emerging markets in different ways – especially compared with historic scenarios – due to “its ongoing transition from a manufacturing-oriented economy to a services-led economy”.
Ceva said that she was in favour of emerging market debt because she felt it delivered greater diversification benefits compared to emerging market equity – with much lower volatility.
"Central banks got ahead of inflation with proactive rate hikes, and corporate
balance sheets have been well-managed."
“Whilst emerging market equities have generated higher absolute returns, when adjusted for the volatility, emerging market debt returns are about 40% higher than emerging market equities,” she said.
She added that the largest emerging market sovereigns and corporates have been resilient in the face of rising rates and tighter financial conditions. “This is because central banks got ahead of inflation with proactive rate hikes, and corporate balance sheets have been well-managed,” she continued.
Similarly, Swiss Re’s July 2023 Sigma outlook projected 4.3% growth in savings premiums in the emerging markets, with most momentum coming from economies in Asia.
However, one important caveat was that investors should be weary of investing in countries expected to be hit by the El Nino/La Nina weather pattern over the next few years – which many have warned will be long and severe, and will likely wreak havoc on local economies.
There are a range of long term tailwinds supporting emerging markets, said asset manager Federated Hermes. These included a “demographic advantage over the West”, manufacturing capabilities, resource advantages, digitisation, and a “focus on developing infrastructure”.
When it came to the common inflation concerns, JP Morgan Asset Management said it believed these conditions had already peaked in the emerging markets area.
Ceva added that current activity indicators showed emerging market growth, excluding China, to be strong – and improving daily.
With developed markets growth stalling, emerging markets – especially the debt sector – could provide a steady companion in years to come. Insurance investment teams will likely look to these areas to supplement income and diversify debt portfolios.
