Emerging market debt: Currencies, curves, and confidence

Discussing how emerging market debt weathered global volatility, capitalized on dollar weakness, and attracted renewed investor interest in Q2, along with insights on where the opportunities may lie in the months ahead. 

Transcript

Paul Mohr

Hello and welcome to the Emerging Market Debt Quarterly Perspectives podcast. I'm Paul Mohr, senior director with Aberdeen Investments. Each quarter we break down the key developments in emerging market debt and share our insights on what lies ahead for the asset class. Today I'm joined by my colleague Siddharth Dahiya. Said recently was promoted to the role of global head of emerging market debt. Sid congratulations on the role, first of all. And, welcome to the podcast. It's great to have you on. 

Siddharth Dahiya

Great. Thanks, Paul. Thanks for having me. 

Paul Mohr

All right. Well, let's go ahead and kick things off with a look back at, the previous quarter, as we, as we usually do. One that began was Liberation Day, which seems like such an eternity ago. Since then, how have emerging markets that, performed overall said, were there any out, any standout segments or regions that deliver particularly impressive returns? 

Siddharth Dahiya

So, second quarter, sort of seen, strong resilience from E.M. bond markets. You know, after a shock at the start of the quarter in the form of, liberation grand, escalation of the trade dispute, particularly with China, which almost, actually imposed a de facto embargo on imports to the US right from its, second largest goods supplier.

As the quarter moved on, markets began to pay less attention to the really aggressive, tariff threats coming from the white House. And also, markets started to believe that, you know, the president appeared to, sort of move more on the side of market stability than chaos. And generally the threads threats, tended to be walked back rather than implemented.

So the market, gained, quite a lot of calm after the beginning of the quarter. In the previous episode of this, webcast. I know that my colleague mentioned, that there was a lack of dispersion in returns between different asset classes of the, we got dispersion this time and mainly driven by EMF.

So if you were to run down a run through the list of, markets, the corporate market actually was the most or least remarkable in terms of, least, positive performance. Just under 1%. The sovereign market was slightly better, particularly in the sovereign high yield space, which had, for the quarter, almost 2.5% and positive performance.

 But then within the high yield space, it was fairly concentrated with, almost 30% returns from Ecuador. Given the surprise election, victory by the incumbent President Obama over there. Argentina returned almost 10%, driven by the disbursement of funds from the I of March. However, Ukraine came under a bit of pressure, given market's optimism about, the ceasefire sort of, taking a backseat.

What was the out, outlier in, in this quarter or in the outstanding performer in this quarter was, local currency? Majority of the returns came from the EMFX. Local currency, unhedged returns were almost 5.5% in the quarter. The standout performers were, places like Brazil and Colombia. And, you know, in, in local currency markets, there has been a low, sort of notable decline in dispersion of returns in this quarter to, in our view, dollar weakness, you know, in general has taken over from domestic policy cycles as the main driver of returns, for local currency.

Yeah. In recent past. 

Paul Mohr

With that being said and said so we saw, Treasury yields rise in the second quarter. Did that play a significant role in dampening and performance, or were there other contributing factors? 
  

Siddharth Dahiya

Not necessarily. So even though the US Treasury yields, were higher in the quarter, even, at a sort of a to your point, probably the most important trend for investors, in the second quarter was dollar weakness.

In general, you know, policymaking in EM becomes much easier when the dollar is weakening. And, you know, EM officials don't have to constantly worry about, rolling and refinancing, of foreign debt, and increasing inflation pressures coming from weak currency. So in a stronger EM FX, weaker dollar environment, it in general is quite positive for the for the EM market.

And was a bigger driver of returns than the any moves in, in, in rates. And in general what we have seen is you know, the weaker dollar, a stronger EM FX market, can also improve returns for duration instruments in the EM which generally, is not supported by a say a weakening treasury market.

Paul Mohr

Okay. Well, let's shift gears a little bit here and let's talk about investor sentiment. So in the wake of Liberation Day and the other events of the quarter, are we seeing any shifts in how institutional investors like pension funds or insurers are approaching the asset class? Are you seeing any signs of positive net close during the quarter?

Siddharth Dahiya

Yeah. And I think there's there's there's many ways to look at this question, actually. So, one of the ways that we can look at it is, you know, general data, from around the world. So in our view, and actually, you know, flow data seems to suggest, seems to suggest this, that there's basically four different kind of investor bases which have, which have demonstrated relatively sharp selling of, dollar assets or, you know, that this would then, imply that they, some of that money would be flowing into EM asset classes.

So one of them is the, you know, Taiwanese based, US dollar debt ETF investors. We saw how strong these dollar was, in the quarter. The other one being FX hedging by, pension funds across, many countries, both in developed and developing markets. European domiciled ETF investors who invest in US equities, they seem to sort of pull back from, a little bit from US equities and in general, you know, global globally domiciled funds which invest in US, that also seem to pull back a little bit.

This is not an all encompassing story, though, because there are certainly pockets of the market which seem to be investing more in the US. So, Korean and Japanese investors seem to be, investing more in US dollar debt in US equities as well. Now, the FX hedging story is quite interesting that we've seen, you know, a number of, stories.

I think it's very well, televised, telling us stories that around, you know, day nation, Australian pension funds, increasing the hedges, on their investments in the US. So, so that is the first part of the story. The second part of the story is the is the flow, the actual flow into EM, so what we have seen is that, in towards the end of last year, we saw outflows from EM. 

And those outflows were particularly strong on the hard currency side. In the beginning of this year, those outflows kind of subsided and we had some inflows, but then outflows picked up again in March and particularly in April during Liberation Day. And all the, you know, the volatility that, arose around it. What we have seen since then is sustained inflow into the asset class.

This is, by the way, EPFR data. So, you know, it's not always entirely accurate, but it gives us a directional estimate quite, quite. Well, what we have seen is that inflows have been particularly strong in the local currency market this year, less so in the hard currency market. And what to me, what is interesting is that when there was a risk off period beginning of this year and late last year, most of the outflows were happening in the in the hard currency market and not the local currency market, which to me points to, somewhat cleaner positioning in the, in the local currency markets, in EM.

And then last, piece on this, I would say, is that, the amount of issuance that we have seen in Em has also increased. And generally you see higher issuance in, when there is good demand from investors. So, for example, sovereign issuance, up to this up to this point this year is, just under $150 billion, which is, near historical highs, only behind 2020.

June was also a very, very strong month, I think the strongest month, in the previous four months. Yeah. So, it seems like investor demand towards this asset class seems to be coming back quite strongly. 

Paul Mohr

Yeah. It's great. It's positive for the asset class and, and that's it's great news to hear on that front. Said beyond the usual suspects then of slowing global growth or renewed tariff tensions that, seem to be occurring on a, on a daily basis, are there any emerging market specific risks that investors should be keeping a close eye on right now?

 Siddharth Dahiya

Look, emerging market specific risks, yes, there are a few. But, you know, I mean, some of the other global risks worth mentioning are, the obvious one, a US recession, which, if and when it comes, will likely lead to, slight widening of spread, in the EM market, although weaker dollar might help the market.

So it would be a sort of counterbalance to widening spread to generally weaker dollar tends to support flows into the the tariff wars you've mentioned. Of course, there's not much I can mention that that means a very, very attentive, you know, discussed, story across the world. And we going to be a very close to the July 9th deadline, and we don't really have much clarity as to where that is going.

One of the very sort of specific, centric risk could be, you know, the and this is not necessarily a short term risk. This could be a sort of a medium term risk as well, if the US tends to, starts to pull out of, you know, IMF and world Bank, this those kind of bodies, this really impacts, the, the lending capacity and, and forces some of the weaker countries in the, to find alternative funding sources when the, you know, markets are tough.

So that can be a challenging, point for some of the frontier countries in the, geopolitics obviously is very important for us, for Em particularly in Eastern Europe around, Russia, Ukraine, that is clearly a risk. And in the Middle East as well be so we've seen in recent times an increase in volatility in, in Middle East.

And then lastly, I would say again, something quite specific to E, m is excessive volatility in, in, in oil prices, you know, very low oil prices, significantly hurt, the oil exporters in m very high oil prices had the importers and sort of and their balances go out of shape. So for us, it's good to have oil prices in the 60s and 70s.

 I think that that that seems to be a sweet spot. But, excessive deviation from here, doesn't bode really well for EM. 

Paul Mohr

So, as with any investment, then, your performance is driven, largely in part by what you pay for your investment and so on. With that in mind, said, what areas of EMD are looking attractive to you on a, on a valuation basis?

Siddharth Dahiya

Yeah. Look, I mean, we invest across, different markets in Em. And, you know, there's always some part of the market which looks attractive to us. So I wouldn't just say that, you know, there's pockets or certain markets which are completely unattractive at the time or something or, certain other markets which have no risks at all.

So my answer would be a little bit more nuanced. I would say, within frontier markets, even though we have increasingly moved our exposures toward, towards local currency, in general, we tend to prefer the, the front end of the dollar curves here. You know, these positions benefit from sort of strong roll down. And generally these countries tend to do liability management.

It also benefits from that. We had in general we have slightly we have moved slightly higher in quality is not so moved from the sort of single B names to the double B kind of names here. The other portion of the market will be like, you know, a certain credits, on the sort of the fringe of the rating bands where we think the market has overpriced, a potential downgrade.

Colombia would be one example. Romania was an example. But in recent weeks Romania has done really well. So less attractive. Definitely opportunities in local rates. The rate cutting cycles, have been shallower than the steep hiking cycles a couple of years ago. Inflation is close to target. Policy rates are still higher than historical averages.

So we think that, you know, there is room for, central banks to, to cut further, and then of course, E.M. currencies, you know, we, we have a sort of a consensus view there, that the US dollar could continue to weaken, even though I think there are risks to that view.

We could discuss that, but that we will. Net net, we are still positive on E.M. currencies and in the corporate world. We are positive on certain parts of the high yield market. We have a structural overweight to some of the, double B, portions of the high yield market where we feel, companies, are somewhat disadvantaged by lower sovereign ratings.

 So even though these are very strong companies with strong balance sheets, they happen to be in a double B country and are constrained by the sovereign rating ceiling. So that seems to be, that is always a sort of a structural overweight for us. And we still see good value in that part of the market. 

Paul Mohr

All right. And, now everyone's favorite part of the podcast, looking ahead to the second half of the year, said, know which parts of the market do you feel are best positioned to really deliver the, the highest probability of the highest returns? And what's driving that? That to you? 

Siddharth Dahiya

Yeah. I mean, this is a this is a crystal ball question, you know, is it very difficult to to predict?

But I would I would lay out a framework here. So look, the FOMC cut rates by almost hundred basis points in 2024. Yet the US remains one of the one of the high yields in G10. Whether you look at spot rates or forward, money market rates. Having said that, the US dollar has weakened by, what, 10% in in the first half of this year, driven by tariff uncertainty, perceived threat to, you know, US institution credibility, fiscal deterioration, all of those things.

Right. And in general, I mean, us dollar weakness has been viewed solely from the prism of, a lack of confidence or a loss of confidence in US exceptionalism. And there there absolutely is some credence to that. But it also lends to another sort of factor, which is that, you know, a sustained dollar weakness is providing a benefit to the global economy outside the US.

You know, US dollar weakness and declining inflation. It allows m central banks to ease monetary policy more consistently. In general, the, the sort of the M monetary policy stimulus that we are seeing, coupled with contained oil prices, a more resilient than expected US economy is generally all these things, you know, point towards, perhaps a better than expected economic outlook in the second half of this year and maybe even 2026.

So I'm not necessarily very bearish about the global economy, about the economies and the prospect returns in US. You know, you hear many market participants say, that the returns have been frontloaded. And, you know, you spreads are low. And I would concede that spreads are not the most attractive. But there are other forces at play here. So you know, re the question for us is, will the US dollar remain negatively correlated with global risk assets, as has been the case, this year?

 And most times, or will it revert back to the regime where, the US dollar is positively correlated with the US asset performance? Now, if it is the latter, then we would expect, some of the, you know, the hard currency markets of em to perform better. If it's the former, then we would expect local currency to continue to perform better in the second half.

One of the risks to to this could be that, you know, obviously the US dollar has depreciated a lot against the euro. And I think we are getting to a point where European authorities are questioning this move and wondering what what happens to their own competitiveness given this strong move up in the euro. So we could see some pause here.

But longer term we think that, you know, m effects would tend to do well, in the remainder of this year. And the, the, the hard currency markets, in em would you know, given a very strong, the very strong carry that they have. The overall returns should be fairly, fairly strong in the second half of this year.

Paul Mohr

Okay. That gives us, something to look forward to, in the, the coming months here. With that, that feels like a good place to bring this podcast to an end. So I'd like to thank you for joining us today. 

Siddharth Dahiya

Thank you very much. Thanks for having me. 

Paul Mohr

And thank you to everyone who took the time to listen. And, if you enjoyed today's episode, then please download our other podcasts from our website or wherever you normally get your podcasts from. Thank you very much.