Pent-up demand for emerging market bonds after investors were side-lined

Soft landings are rare, but they do happen. In our baseline scenario, we expect a flat, brief recession in the US and a recovery in economic growth over the course of the year. Given this scenario, we see attractive entry opportunities in emerging market corporate bonds for investors with a longer investment horizon. Despite the substantial rebound from the lows at the end of October, investors are still benefiting from a high carry and the strong fundamentals of companies located in emerging markets.

China’s surprisingly sudden and complete exit from its extremely restrictive Covid policy has distinctly improved investor sentiment towards emerging markets, as is apparent from the record-high inflows of about USD 8 billion into the asset class since the beginning of the year. As a result, the International Monetary Fund has upgraded its growth forecasts for emerging markets and now expects GDP growth of 4.0% in 2023 and 4.2% in 2024. Despite that, many investors are still underinvested in emerging market bonds. A further reduction in this underweight should give the markets an additional boost.

On the economic front, we are seeing inflation come down faster than expected – with a weaker US dollar also helping on this score. At the same time, monetary policy – at least in the US and Europe – is still very strict and is likely to lead to a further slowdown in the economy. As for emerging markets, interest rates appear to have already peaked given that these countries started hiking much sooner. In addition, China’s exit from its zero-Covid policy is likely to fuel economic growth and further help to widen the gap between emerging market and developed market growth.

The strong fundamental position of issuers is also reflected in default rates, which are likely to move down into single figures following the recovery in the Chinese real estate market – lower than initially anticipated.

Our portfolios are currently focused on carry opportunities and securities with a higher credit quality, especially in the BBB and BB rating categories. By virtue of their attractive carry, solid high yield bonds create an effective performance cushion. Broad diversification and careful security selection are advisable in order to minimise risk. Since markets will remain data-dependent for some time, this positioning enables us to weather any potential volatility without a major deterioration in credit quality as well as potentially taking advantage of market upheaval when it becomes apparent.

At the country level we continue to favour Mexico given that its geographical proximity to the US enables it to benefit from the current nearshoring trend. We are also focused on companies in the commodities sector, including oil and gold producers, which are the beneficiaries of the recovery of demand in China.

On the whole, therefore, we are optimistic about the return potential offered by emerging markets this year.