The following reflects the personal views of Evariste Verchere and is provided for informational purposes only. It should not be construed as investment advice.
Recent years have seen higher Treasury rates and a strong US dollar shape the landscape for emerging market bonds. We believe that recent USD weakness, Federal Reserve monetary easing, and ongoing trade tensions are significantly altering the economic environment and impacting all financial assets, including emerging market bonds. A weaker USD and lower Treasury rates are making hard currency debt more affordable and are providing local central banks with greater control over their own monetary policy. However, it remains unclear how the dollar would perform against emerging market currencies in the context of a potential global economic slowdown.
In the current market environment, our focus is on both income generation and resilience. While still attractive relative to other asset classes, emerging market credit spreads are low by historical standards. In response, we seek to capture idiosyncratic risk premia through short-maturity, high-yield bonds. The advantage of emerging market corporate credit is that certain risks, such as political or company-specific factors, can be diversified, thus potentially offering attractive risk-adjusted returns. To balance this, we maintain allocations to high-quality bonds positioned in the intermediate segment of the USD yield curve. The rate factor is particularly appealing at present, as it can offer downside protection as well as elevated real yields.
On the credit side, we favour short-term bonds, as we prefer to focus on income generation rather than potential spread tightening. On the rates side, we prefer the intermediate segment of the yield curve. While we expect the shorter end of the curve to remain volatile due to noisy economic data leading to regular repricing of Federal Reserve monetary policy expectations, the longer end could be affected by increasing Treasury supply, inflation and concerns over the budget deficit.
Economic forecasting is likely the biggest headwind, as frequently changing US economic policy makes it difficult to establish a long-term macro-fundamental view—which could be proven wrong just a week later. However, frequent headlines and a volatile environment create dispersion, thereby favouring a valuation-driven approach. It is important to ensure that position sizing is appropriate, to prevent any single exposure from having an outsized impact on overall portfolio returns.
Geopolitical conflict and tension, while undesirable, can nonetheless create opportunities in emerging markets by providing uncorrelated risk premia that can be diversified. Appropriate position sizing remains crucial, as investors need to be able to absorb potential losses. In addition, we believe that these kinds of events strongly support the case for active versus passive management, as well as for maintaining flexibility around the benchmark. Such events can dramatically increase the volatility of an index, where a single risk event may drive most of a fund’s return. Active portfolio management, with flexibility around the initial benchmark, can help to stabilise fund returns and keep the risk profile better aligned with investors’ objectives.
When considering deglobalisation and the possibility of new unestablished trade alliances, we believe it is important to focus on countries that are self-reliant. In the past, investors preferred countries with a current account surplus, as this provided access to USD. However, we now believe that such surpluses may also indicate significant exposure to external trade. At present, we favour countries whose growth models are driven by strong domestic demand, secure supplies of essential goods such as energy and food, and stable domestic industry supply chains. We also place significant emphasis on the capacity of central banks and the financial system to cushion economic shocks. For example, we consider FX reserves, central bank credibility, and the extent of foreign ownership of debt. Ultimately, we seek countries and companies that demonstrate resilience to external factors.