Further dispersions make the case for active management
“The covid-led economic disruptions which started in 2020 and are still present or resurfacing across the world, have not only widened the gap between developed and emerging markets but have also created further dispersions within emerging markets”, says Michael Wehrle, Head of Investment Solutions at BlueOrchard. “In our view, the dovish monetary policies witnessed over the past two years have flooded markets with liquidity and narrowed disparities. With such high levels of liquidity available, lenders were incentivised to support borrowers across the quality spectrum, thereby providing financing to weaker borrowers as well. In our view, this process tends to reduce the gap between borrowers’ varying credit profiles. Tapering, however, is likely to have the opposite effect as it will reduce the liquidity available in the system. As a result, we expect to see wider dispersions amongst issuers in the coming year which will materialise in various ways.
First and foremost, the pace of the vaccination program varies widely across emerging market countries. It goes without saying that the reopening of economies worldwide and the rebound that should occur as a result are highly contingent on the speed at which governments can inoculate their population. In addition, the volume of exports witnessed in 2021 have hugely benefited exporting countries and notably commodity exporters. Also, commodity exporters, such as Colombia, have been beneficiaries of stronger exports in that it was providing them access to USD at a time when the USD was strong. However, countries whose economic model is more service-oriented, such as countries that are heavily reliant on tourism, have suffered over the course of the past year. Those countries were adversely impacted as muted tourism activity weighed on their growth but also because they were left with limited access to USD. A separate issue is that some emerging market countries went into the covid crisis with weaker fundamentals than others and are already seeing their monetary and fiscal policies tighten although their economies haven’t fully recovered from the covid-led downturn. Finally, a heavy political agenda notably in Latin America will continue to be a driver of volatility and uncertainty in the coming months. We hence expect dispersions between emerging market countries to widen over the coming year. In such an environment, we believe having a selective approach and being active will be essential to generating alpha in 2022.”
Leveraged corporates most vulnerable to higher US rates
Florence Birkett, Portfolio Manager at BlueOrchard adds: “One of the key risks for emerging markets in 2022 will likely stem from the Fed’s tightening cycle. Funding costs will become more expensive for issuers financing a portion of their debt in US dollar. Countries and corporates with non-USD denominated debt are also likely to suffer as higher USD interest rates will push other rates across emerging markets higher.
It is however essential to emphasise that the current tightening cycle in the US is drastically different to the taper tantrum witnessed in 2013. The key reason is that most emerging market countries are going into this cycle with much stronger fundamentals than nearly a decade ago. That being said, corporates displaying high leverage levels and being highly reliant on wholesale funding will inevitably be the most vulnerable to higher interest rates. We hence believe that it will be crucial to focus on issuers with adequate leverage profiles over the coming year. In advanced economies, high yield-issuers are usually assigned a below investment-grade rating because of a high leverage profile. In emerging markets, however, we believe that is not necessarily the case. In our view, there are many reasons that can drive corporates to be assigned a high yield rating in emerging markets that is independent from their debt profile. For instance, a company with a solid credit profile but implemented in a country with a high yield rating will very often be constrained by its sovereign rating. A good example would be IHS Holding, a high yield-rated tower operator focused on numerous emerging markets. Despite its decent fundamentals, the company is constrained by the sovereign rating of Nigeria (B-).
In our view, emerging markets will offer attractive opportunities in 2022. Active portfolio managers will be able to invest in select high yield names whilst limiting exposures to the more levered issuers who are most at risk in a US rate tightening cycle. Finally, we believe that unlike portfolios heavily concentrated in few highly levered issuers, having a portfolio holding numerous bonds displaying idiosyncratic, uncorrelated risks will provide better diversification and more attractive risk-adjusted returns.”
Fixed Income reinstated as a diversifying tool
“During the Covid-crisis, most Central Banks across the world stepped in to support their economies and implemented accommodative monetary policies,“ says Evariste Verchere, Portfolio Manager and Head of Public Debt at BlueOrchard. “Those policies, as their goal intended, pushed yields on Fixed Income instruments lower. Over the past numerous decades, Fixed Income had been used as a diversifying tool in multi-asset portfolios. The rationale behind was that fixed income and equity instruments tended to be negatively correlated, i.e their prices usually moved in opposite directions. In 2020, however, the yield offered on fixed income instruments was so compressed already that Fixed Income struggled to play its diversifying role. In other words, the room left for bond yields to compress any further to offset a move downwards in equity prices was very limited. As of December 2021, however, we faced a drastically different environment with the Fed having started tapering its asset purchase program and markets pricing in several rate hikes for 2022. Initially, a move higher in yields will hurt bond prices. Duration management will notably be essential in order to protect fixed income portfolios. However, we believe that over the longer run, higher overall rates in fixed income will reinstate the asset class as a diversifier.
We are strongly convinced that the environment over the next twelve months or so will present numerous relative value opportunities for active portfolio managers. Investors will notably be incentivised to differentiate even further between issuers. The ability to invest in select names and to manage duration actively will be key in delivering solid, risk-adjusted returns in 2022.”
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