Karina

“Hello and welcome to the latest PineBridge investments podcast. My name is Karina Graff, and I work in our Client Solutions team in Germany. I'm delighted today to be joined by two members of our Emerging Market Fixed Income team. Luke Codrington, Co-Head of Global Emerging Markets, and Jonathan Davis, Client Portfolio Manager. Today we're going to discuss how EM bonds can address the challenges of a lower yield environment. Maybe let's start off by me quickly setting the scene. As we know, central bankers in Europe and the US have begun cutting rates, intending to normalize monetary policy and support a gradual slowdown of economic growth. While these rate cuts support total return across fixed income, they also may pose a challenge to investors who will need to consider a new allocation strategy to maintain yield levels within their fixed income portfolios.

And with that, let's dive right in John, let's start with you. Considering the shifting global macroeconomic environment, what would you say makes emerging market debt an essential consideration for investors?

Jonathan

Thanks. Karina, really happy to be with you, and think it's a great time for us to be talking about emerging market debt, as you mentioned, given the expectations for lower yields across global bond markets, and certainly with some of the macroeconomic concerns that we'll touch on over the coming minutes. I think it's important, before getting into that answer, to just contextualize emerging markets debt a little bit.

The phrase “Emerging Markets” refers to a grouping of countries that span the globe in which 85% of the world's population resides. Those grouping of countries contribute roughly 45% to Global GDP and the bond markets of both governments and corporations that are issuing public debt across that grouping of countries totals nearly $30 trillion in market cap. Now for international investors, such as PineBridge, not all of that market is accessible, but the accessible market is around $8 trillion.

So it's a substantial component of global bond markets. Yet if you look at most of the major global bond indices, the representation of EM is vastly short of those numbers that I just cited, the 85% population and 45% GDP contribution and 8 trillion in market cap. You have a hard time finding a similar level of exposure in global bond indices.

So, one thing that we've consistently heard from clients and partner with clients on is to make up for that sort of deficiency of exposure in the part of the world that is underrepresented in their bond markets.

The other thing that that is important to put in the context, when we talk about the $8 trillion of investable market cap for international investors, around half of that is US dollar denominated bonds, which is very important for investors that are investing in the US or Europe or UK, where their assets and liabilities tend to be in reserve currencies. It makes for a more sustainable allocation to investing into a hard currency bond market where you don't have to deal with that foreign exchange volatility.

So for us, what we typically partner with investors in this part of the world upon is strategies that look at that $4 trillion of hard currency bond to market, and those markets tend to have delivered very strong risk adjusted returns over full market cycles, particularly EM corporates, where, when you think about Sharpe ratios, risk adjusted returns, the Sharpe ratio of the EM corporate bond market has consistently been among the highest of all public bond markets throughout various market cycles. So, we think from a diversification standpoint, from a risk adjusted and return enhancement type of allocation standpoint, EM debt makes for a strong strategic allocation in a fixed income portfolio.

To your question in terms of timing the allocation, I think one of the things that we have to sort of address is valuations. And across all public credit markets, valuations do appear tight relative to their historical averages, and that's certainly true of EM bond markets. And if you are looking at EM spreads relative to their own trading history, we're near the tights of their historical range. If you look at EM spreads relative to their counterparts in developed bond markets, a little bit more value on offer there, but still toward the lower end of that historical range.

I think the difference that we would sort of highlight between EM and DM when you're looking at tight valuations, is when we're talking about developed market credit, we're thinking about an economic outlook and a fundamental outlook that is a bit less certain than what we find in emerging markets.

There's certainly slowing growth across Europe and the US, and as you mentioned, central bankers are trying to navigate that soft landing of disinflation and slowing growth and prevent or ward off a contraction of growth. We don't have that same fundamental concern in EM, right. So where you might say valuations are tight, valuations are tight relative to their historic levels, but they're also maybe reflective of what we feel is an improving credit profile across the market.

And so maybe what is today's tight valuation is maybe more fair value for a better fundamental credit outlook.

Karina

So you mentioned valuations, what right now is giving you confidence in the pricing of EM bonds? And what could investors be missing out on by not allocating to EM?

Jonathan

I think, for starters, valuations being tight is very reflective of the strong technical components, supply and demand technical, that exist across global bond markets. So that's supportive of EM, just as it is in developed markets. The difference, as I mentioned, when it comes to the fundamentals and it really hinges on a few things. To begin with, faster growth, faster economic growth, faster revenue growth across EM. So, from an economic perspective, the EM growth premium over DM, so GDP growth, EM over DM, that spread is accelerating, and it's kind of a reversal of a trend that we've seen of converging growth, that basically was convergence between EM and DM from about 2010 onwards until around like 2022.

We're seeing a re-acceleration of EM growth relative to DM growth over the two sort of post Covid years in this cycle. Comparing that to the last time of EM growth accelerate and in sort of the early 2000’s, you know, in the early 2000’s you had Chinese growth. That was really sort of the driver of EM growth overall. And what's different this time around is the growth acceleration of EM is very much driven outside of China.

So much has been made of the Chinese economy and economic outlook there, and just recently, policymakers have stepped up their commitment to supporting a gradual, managed, sort of slowdown of economic growth. Our expectation is for Chinese growth to come in just under 5% this year and further sort of moderate around the mid 4’s next year, which is by no means a recessionary environment, but certainly stands in contrast to that early 2000’s where you had double digit GDP growth in China on an annual basis.

So, where is that growth acceleration coming from, from an investor standpoint. It's a varied group of countries which provides an increased sort of opportunity set of areas to tap into. So, you know, sticking within Asia, major economies, India, Indonesia, Philippines, will all likely print GDP growth in both 2024 and 2025, over 5%, in India's case, over 6%.

So, we're seeing robust growth elsewhere within Asia. Thailand is another economy where we're seeing a substantial increase year on year, this year and next year. Elsewhere outside of Asia, looking across Latin America, we expect to have above trend GDP growth this year and into next. Same thing goes for the Middle East, where we're seeing above trend growth. So there's sort of a diversification of that growth engine that we didn't have in the early 2000’s where China was really sort of the engine of that growth premium.

The benefit as a debt investor to faster growth is you get an improvement in debt metrics and EM versus DM debt metrics, emerging markets have historically had a more, I should say, sort of conservative approach to managing balance sheets, whether that's a government balance or a corporate balance sheet.

Sticking with the governments, you know, if you look across EM and there's a wide range, you know, from an index perspective, we're talking about a grouping of countries that are around 80 different countries. So, you'll see countries in, say, the Middle East, where their debt to GDP is around 25% debt to GDP, and some areas where you're north of 80%. But on average across EM, debt to GDP from a government perspective, is around 70% just below 70%. You compare that to the US, where debt to GDP is over 120% in the US.

So, from a country perspective, a more conservative sort of debt burden on the EM countries. Thinking, then to the corporate market, net leverage ratios amongst EM corporates versus the DM peers are substantially lower. So from an IG perspective, you know, we're coming in below one turn of net leverage, around 0.9 times net leverage to earnings for EM IG corporates. And you compare that to 2.7 times net leverage for US IG, and 2.5 times for European IG.

And the high yield, it's a similar story with 2.3 times of net leverage in among EM high yield corporates. And you compare that to 3.4 times for US high yield issuers, and 4.5 times for European high yield issuers. So again, a much stronger base of credit metrics. An increase in that incremental growth relative to DM, only improves that sort of set ratio by expanding the denominator there of those metrics. So strong credit metrics that we expect to continue to get stronger, given the positive fundamental outlook that we have for EM, both governments and corporates alike.

Karina

Perfect. Thank you. That's very helpful. So looking back, what parallels can we draw from past rate cut cycles in terms of investor behavior and EM debt performance?

Jonathan

Yeah, so thinking back over the last, you know, two and a half decades, we have gone through three rate cut cycles. The two most recent were in response to financial or health crises. The rate cut cycle the early 2000’s probably is most indicative of what central bankers are attempting to navigate today, that gradual trend of disinflation to target a gradual slowdown of economic growth and potential weakening of labor markets.

You know, when we think about that period, hard currency, EM debt delivered very strong returns in excess of US Treasuries and in excess of similarly rated corporate credits among the developed market issuers. So, from an EM perspective, sovereign debt delivered around 17% annualized return during that early 2000’s rate cut cycle. This predated the corporate index. So, we'll focus purely on the sovereigns from that historical comparison standpoint. But again, during that rate cut cycle, we see very strong total returns, you know, comparing sovereigns and corporate sovereigns around two and a half years longer duration than corporates.

So, within a cutting cycle, you'll get more of that benefit of the total return from being in the longer duration asset classes. But certainly there's a full credit curve to be taken advantage of within the corporates as well. So we're benefiting from the nominal decline of treasury yields.

Thinking ahead to at some point reaching that neutral rate, and what happens then, when central bankers reach their neutral rate and rates are sort of steady and low? There we have a bit more sort of data points that we can compare across EM and DM. But thinking about those similar sort of periods of time when we've completed a rate cut cycle and the Fed or the ECB is able to maintain rates at stable and low level? During those periods again, we see outperformance of EM debt in the hard currency markets for both US treasuries and corporates.

So, thinking over those periods, on an annualized basis, we're seeing returns in excess of 8.5% across both sovereign and corporate markets. You compare that to US credit that's returning, say, around 6% and more than 7% excess returns over US Treasuries. So again, you benefit from carry, you benefit from a flow of assets from a lower yielding market into the higher yielding market. And you do see strong total returns for EM in both the cutting cycle and certainly then in the stabilization cycle.

Karina

Thanks, John. That background is really helpful. And now to kind of bring it back to the present situation, how do you feel have the recent interest rate cuts by the Fed and ECB influenced the attractiveness of EM debt? And also, do you anticipate any specific impacts on EM debt pricing or fundamentals as a result of this?

Jonathan

That's a great question, and maybe I'll start with the fundamentals first. I'd mentioned earlier, the faster growth outlook, the improving debt metrics. Part of that improving credit metrics will also come from the lower rate environment. Easier monetary policy, looser financial conditions, easier to manage or maintain debt burdens across EM. So, you do see a fundamental benefit right there from ability to refinance at easier levels, and that all kind of folds into the improving credit story. As I mentioned earlier, net ratings migration positive outweighing negative ratings for both sovereign and corporate issuers already this year, and that trend is expected to continue next year, and the lower rates are certainly a component of that.

So, from a fundamental perspective, certainly there's positives for Emerging Market borrowers. The other point to make of support for EM, and it's a big component of why EM has performed well in rate cut cycles in the past and in lower rate environments of the past, is that you do see a flow of capital. For those of us that were having client conversations in the period between 2010 and 2018 it was consistent search for yield.

And when you see low rates, and I don't think anyone expects rates to reach the low levels that they were in the past cycle, but investors have become used to hitting yield targets that will be very difficult to achieve in their domestic bond markets - if you're thinking about investors into the US or Europe or the UK, and therefore, you know, they'll be looking to external bond markets or foreign bond markets. EM is an area where they can still potentially hit those yield targets.

So, you do see a flow of capital coming from developed markets into EM, which certainly supports the technical component of bond prices and contributes to that excess return within EM. And beyond the support for the fundamentals of EM coming from lower rates, you certainly see a contribution to stronger supply and demand technicals, Luke, how do you see that playing out on the desk and bond pricing?

Luke

Yeah, thanks, John, today we are seeing that crossover bid come into the market, and the clearest way of seeing that is with the new issue order books. So, we've had a significant pick up in issuance since the beginning of September, as have all public debt markets as the Fed started cutting, and rates have come down, but we are seeing multiple books oversubscribed multiple times, and that's been driven in part by crossover investors from developed markets looking to EM deals to lock in that yield premium that you've been talking about.

And just as with previous cutting cycles, that's kind of the first avenue in terms of demand. And then down the line, you'll see flows into dedicated EM bond funds as the allocations start to increase. So, from that standpoint, the technicals are starting to improve. And then if you look going forward, the total return outlook is fairly constructive, particularly given you know the limited supply that you discussed and the strong fundamental base that we're starting with.

Karina

Thank you, Luke. And now to kind of switch gears, I have to ask the burning question, how might the result of the upcoming US elections impact emerging markets?

Luke

Yeah, good question. I think it's worth noting first, actually, that we've had 23 elections in EM this year, and about half the adult population of the world will vote. But obviously the focus right now is on November and the US election, particularly in terms of the impact on EM. But in terms of the US impacts, if you look at fiscal policy, I think the base case is to have a divided government. But if we had either a red sweep or less likely blue sweep, we're likely to get better EM fiscal policy, and that probably implies higher yields, which will impact all credit markets, broadly, but especially EM as well, and also probably we’re going to see a stronger dollar in either of those scenarios.

But that's not the base case. And then, you know, a divided government, which is probably what we're going to get, is likely to result in kind of no major shift in the status quo. We're probably going to get more of the same in terms of rates and the current trajectory. The main impact on EM will actually be from trade policy and foreign policy, though, you know, and by all accounts, we're probably going to see a continuation on both fronts, if Harris wins, but if Trump wins, we could see changes, and are likely to see changes in both on trade. You know, Trump has campaigned on 60% tariffs on Chinese imports and a 10% tariff on global imports.

The inflationary impact for these in the US will again lead to higher yields. But from a Chinese perspective, tariffs, if they are fully implemented, this could hit Chinese GDP growth anywhere from 90 basis points to 240 basis points in the most extreme case, given Chinese exports make up 15% of total exports, that is, Chinese exports to the US make up 15% of total exports.

On foreign policy, there could be a negotiated peace between Russia and Ukraine with the new Trump administration, although this is unlikely to result in the immediate easing of sanctions, you know, any follow through impact on commodity prices. And then with the Middle East, which is obviously front and center of everyone's minds, it's not clear whether a Trump administration would significantly change the current trajectory, but at the margin, you could say there could be some support for Israel.

And whilst you know Trump, as we discussed, is going to be harsh with China in terms of trade, the impact in terms of support for Taiwan isn't clear cut, given the comments that he's made to date. I think either way, it's safe to say that, you know, foreign and trade policy will be less predictable, but this creates market dislocations. We may have to be checking tweets on a daily basis again, but it also creates opportunities. And I think the main thing for EM is that this is nothing new.

You know, EM governments and companies have been navigating, you know, US foreign policy tariffs and trade restrictions for the past seven years. And plus, you know, this time, EM is less reliant on exports to the US, so the majority of trade, you know, is intra EM trade, rather than with developed markets. And you know, as JD spoke to earlier, the driver for the expansion of the differential and growth between EM and DM isn't China, it's the rest of Asia and the Middle East, and to a lesser degree, LATAM and their growth trajectories are unlikely to be impacted by changes to trade policy that we discussed.

The recent policy support announcements from China just add to probably a growth in the differential from what it already is looking like. And you know, while some countries and sectors will be vulnerable to the trade policy, others may stand to benefit. The key is being selective. If you look at Mexico, a 10% tariff will impact some industries more than others, but other companies have operations in the United States, and so will be well insulated.

The near shoring phenomenon is unlikely to be halted even with trade tariffs like that, because the benefit to companies about near shoring is to minimize geopolitical risk. And also, the cost offset is not going to be offset with that tariff. So that outlook isn't going to change significantly.

And also for us, the joy of focusing on this many countries and this many companies is that there's plenty of domestic focused companies and benefiting from better EM growth, or indeed, those have very little exposure to the US, and those are the areas where you still see value and could see opportunities going forward.

Karina

So it sounds like you're not too concerned about what's to come. Can you elaborate on how you protect against all the risks that you just mentioned? And also, could you talk a bit about the opportunities that you're currently seeing?

Luke

I mean, in terms of the opportunities, as I mentioned, the key is to be selective. So, within Asia, we see opportunities in the tech names that are domestically focused. You know, we're seeing improving credit trajectories amongst those. Similar goes for Macao gaming, where you’re still seeing a recovery post Covid and relatively attractive yields and some select commodity producers are attractive. But that's not really broad based on sector, more name specific. Within this time zone, within the CEEMEA region, I think some Middle Eastern real estate companies, as well as infrastructure and pipeline bonds, the latter of which offer really decent yield for the raising bucket and steeper curves, could offer decent opportunities going forward.

And likewise, you know, the economic recovery in Turkey means that both sovereign and financials and certain select corporates are improving, and we see value amongst those. And then on the sovereign side, you know, there's select African countries and Middle Eastern countries which do have attractive entry points. And then in the latter, it’s kind of a more of a focus on the credit trajectory of certain sectors which are improving or certainly stable - and that's protein, pulp and paper, transportation. And you know, as I mentioned earlier, we think there's going to be opportunities in Mexican consumer names that have a US footprint, if spreads move around the election. And you know, as always, there's opportunities in the sovereign high yield space in the region on improving stories.

Karina

Right, you said the key is to be selective, but that sounds like a really wide range of good opportunities. So maybe turning back to John, how do you actually sift through all of these and end up making your selections.

John

Well across the hard currency bond market, which we've been focusing on here, there's over 900 different issuers across around 80 countries dealing with, you know, such varied industries as Luke just mentioned, even, and this is on the short list of areas we're looking at. We're looking at tech companies, we're looking at paper companies, we're looking at banks, certainly miners, utilities. The only real way to maximize the value and limit the downside risks that are inherent with such a wide opportunity set is to have investment resources, locally based investment resources, if you can manage.

And I think that's one of the areas that we've been particularly well positioned to grow our partnerships with investors. In PineBridge we have 18 analysts on the EM Fixed Income team. These are not shared resources. These are purely dedicated to analyzing either sovereign or corporate issuers. Eighteen analysts spread across all the regions that we covered, Hong Kong, Singapore, London, New York, Santiago. So, we have local resources, speaking the language, meeting with government officials, management teams on a consistent basis.

Karina

Thank you so much, John, we've covered a lot of ground today. So before we wrap up, Luke, any final words from you?

Luke

I think the key thing that we've been trying to get across today is that, yes, while there's a lot of geopolitical risks currently in the market, and with the upcoming US election, EM is set to benefit. And if you look at historical cycles, in rate cutting cycles, and importantly, when EM growth is outperforming DM growth and that differential is expanding, both of which are occurring at the moment, EM does tend to perform very well, and it's from a stronger base this time. As JD very kindly outlined, in terms of the better fundamental strength that we have currently going into these risks, means that any spread widening or pockets of opportunity and market dislocations, are areas that we're very happy to climb into, and we can do that with a significant confidence because of the size of the investment team and the fact that we've been doing this for many years. It is a big and diversified market, but that creates more opportunities.

Karina

Thank you, Luke. I hope that you found our conversation today interesting, and that you're walking away with some insights and food for thought. You can find out more on our website, PineBridge.com

So I'm left with thanking you all for listening and of course, thank you to Luke and John for joining me today. We hope that you will join us again to listen to some of our upcoming episodes. Thank you very much until next time, thanks for listening.”

ENDS