In a world where the growth outlook in the second half of this year could come under pressure, this lower-quality portion is where investors should be most selective.
A Bumpy Start to China’s Economic Reopening
It’s been clear for a while that global growth is under pressure. But, in our view, emerging markets are poised to grow faster than developed markets over the coming year. A lot could depend on China. China’s decision to abandon restrictive zero-COVID protocols has provided marginal benefits to emerging markets, but it’s been a bumpy road. As we expected, China’s reopening hasn’t supercharged the emerging-market growth outlook, and recent economic data have been underwhelming so far.
The initial bounce from China’s reopening has faded, and policymakers appear to have moved economic performance higher up their priority list, with Beijing cutting a series of policy rates to help support the economy. Although far short of past fiscal stimulus measures, these efforts should help offset the slowdown in domestic demand and, in turn, support emerging-market asset price performance—particularly important if global growth underwhelms in the second half of 2023.
We’d like to see more evidence of increased consumer spending from China spilling over to neighboring markets in Central and East Asia. This could take the form of increased tourism by Chinese nationals or an uptick in trade between China’s major trading partners—including the 10-member Association of Southeast Asian Nations.
It’s been said that when China sneezes, the rest of the world catches a cold. Conversely, we believe a return to good health by China would bode well for its closest neighbors.
Diversification Coming Back into Balance
Diversified investors have at least one trend working in their favor. Traditionally, there has been an inverse correlation between duration-sensitive assets like US Treasuries or other developed-market sovereign debt, and risk assets like credit spreads. Last year, that correlation turned positive, which weighed down returns when both sectors stumbled at the same time.
Now, the correlation between duration and risk assets has returned to negative, which should aid investors’ diversification efforts and improve the risk/return profile of emerging-market hard-currency bonds, which have both duration and spread components that offer attractive long-term risk-adjusted return potential.
Have Emerging Markets Turned the Corner?
With the bulk of monetary tightening over and China abandoning zero-COVID policies while incrementally ramping up economic policy support, two primary headwinds to emerging markets are easing. In this more subdued environment, emerging-market central banks may even have runway to reverse previous monetary tightening.
Conditions are increasingly favorable for emerging-market bonds to regain their footing—particularly in local duration. With investors generally underallocated to emerging-market debt following the worst year of asset-class outflows on record in US-dollar terms, renewed inflows could provide added momentum, although investors will need to be particularly selective in the lowest-credit-quality names.
Investors should also bear in mind that, while emerging-market debt represents a large and growing percentage of the global fixed-income market, it isn’t a monolith. Rather, it comprises more than 80 countries split across multiple asset classes and different currencies—making both security selection and asset-class selection critical.