The Case for EM Bonds

Chia-Liang Lian, CFA

Emerging markets (EM) debt is regaining investor attention after a prolonged period of disinterest.

With strong year-to-date performance across EM currencies and equities — and a surprising resilience to global shocks — we believe the asset class is approaching a long-awaited turning point to regain eminence.

In this note, we revisit the evolution of EM bonds as an asset class, assess the factors behind the benign neglect in the past decade, and evaluate the arguments for an imminent revival.

How EM Debt Became Mainstream

Around the turn of the millennium, EM debt experienced a significant surge and solidified its status as a legitimate asset class. One cornerstone of its ascent can be traced to China, whose WTO accession in 2001 led to a quadrupling of its economy within a decade. Specifically, its infrastructure-centered expansion generated a positive ripple effect on commodity-heavy EM countries. The expansion of global trade, alongside thawing tensions post-Cold War, brought large EM nations to the forefront of the world stage. Russia was a member of the G8 between 1997 and 2014, while the acronym BRICS — referring to Brazil, Russia, India, China, and South Africa — found its way to the economist’s lexicon.

The liberalization of global trade had at least two implications for developed economies. First, low-cost EM producers helped drive down global inflation. Second, accumulated EM trade surpluses were recycled into safe-haven assets, particularly US Treasuries. Both developments, occurring alongside internal weaknesses in advanced countries — deflation in Japan and fiscal profligacy in peripheral EU countries — led to an extended period of low or negative yields. Bolstered by a resulting wall of global liquidity, the investment backdrop was thus ripe for risky assets, of which EM debt was one key beneficiary.

As it turned out, a confluence of factors — the adoption of currency flexibility, increased access to local bond markets, and wide interest rate differentials — served to reinforce the value appeal in EM. Favorable economic prospects bolstered the case for currency appreciation. In Asia, the unprecedented currency shock emanating from the 1997–98 financial crisis presented investors with opportunities to acquire assets at a discounted price. A revaluation of the Chinese Yuan in 2005, in tandem with the country’s vastly improved external balance, marked a formal abandonment of its peg against the US dollar. On the other hand, the high-rate environment in Latin America caught the attention of yield-hungry investors. Indeed, so massive were the foreign inflows into Brazil that a financial transaction tax — as high as 6% in 2010–13 — was applied at the point of purchase of local bonds.

Historically, the universe of EM debt was centered almost entirely on Latin America. Bank proprietary desks and fast-money traders were the main players. Opportunistic flows, typically aimed at attacking pegged exchange rates deemed overvalued, proved immensely disruptive to policymakers. The turning point came in the late 1990s, when the Asian financial crisis and the Russian default widened the catchment area. As the EM debt universe expanded, long-term strategic investors began to emerge, alongside the spawning of a family of benchmarks. From a high of 85% in 1994, the Latin American share of JPMorgan’s US dollar-denominated EM index has declined to 35% currently. With the investment thesis flipping from “short” bets to “long” allocations, EM debt was thus transformed into a mainstream asset class.

The end result was a win-win outcome. For investors, EM debt offered the benefit of international diversification at a time when the world economy was becoming more integrated. EM policy makers welcomed the shift in the investor base away from “tourist” flows that had exacerbated past boom-bust cycles. A combination of supercharged growth and minimal inflation was a goldilocks scenario for EM. With secular forces ostensibly on the side of EM, it was hard to resist the appeal of the asset class. Indeed, the lovefest proliferated in the aftermath of the global financial crisis in 2008–09, fueled by widespread disenchantment of developed markets.

When The Music Fades

However, market strength began to falter in the first half of the 2010s. At the risk of oversimplification, this can be attributed to three key developments for EM.

First, after President Xi Jinping took office in 2013, China downshifted its growth target and redirected its policy focus to addressing internal imbalances. To be sure, such concerns were hardly new. In 2007, then-Premier Wen Jiabao had characterized the country’s GDP growth as “unstable, unbalanced, uncoordinated, and unsustainable.” With the benefit of hindsight, extrapolating China’s breakneck expansion post-WTO into the future would inevitably overstate the country’s secular potential. Fears of an economic hard landing have been widespread in recent years, given policy crackdowns on housing and the pursuit of a zero-COVID strategy.

Second, the geopolitical landscape has deteriorated markedly, with Russia’s occupation of Crimea in 2014 marking a turning point. The market impact climaxed eight years later, when the Russia-Ukraine war led to sanctions by the West on Russia and Belarus. Since 2017, select US restrictions on financial transactions with Venezuela and military-linked companies in China have been in place. These changes have a deleterious impact on EM, as they pose operational challenges for affected securities and raise custodial concerns regarding local currency instruments. Concurrently, on the domestic political front, policy heterodoxy began to rear its ugly head in several EM countries, including Argentina, Lebanon, Sri Lanka, and Turkey.

Third, then-Fed Chair Ben Bernanke’s hint in 2013 at a reduction in its bond-buying program stoked investor anxiety; the subsequent spike in Treasury yields triggered significant capital outflows from EM. Figuratively speaking, the so-called taper tantrum pulled the rug out from under the EM smorgasbord, exposing the excesses of market fervor even as global growth decelerated. Notably, the impact was uneven, weighing on countries that were most vulnerable to higher US funding costs. In Latin America, Brazil was especially hard hit by high-profile scandals (state-owned oil company Petrobras) and a series of corporate defaults. The recovery process for foreign investors proved onerous in many instances, raising yet another red flag for the asset class.

It is therefore no surprise that EM developments over the past decade served to deepen skepticism of foreign investors. This has been especially so for US-domiciled investors, as the uninterrupted outperformance of domestic equities vis-a-vis the rest of the world reinforced the home country bias.

Could This Time Be Different?

At first blush, the incipient interest in EM seems odd, given the absence of critical ingredients for EM debt outperformance — strong growth, geopolitical stability, and easy liquidity. Global trade has been a lynchpin of economic prosperity for EM, since by definition, purchasing power emanates from advanced countries. Uncertainty surrounding the US trade policy will have a negative feedback loop on its EM trade partners. At the same time, international relations have become more intricate and unpredictable. On the monetary policy front, despite the post-COVID tightening being behind us, a reversion to ultra-low rates does not appear to be a plausible scenario, even if the Fed decides to loosen policy later this year.

The Case for Cautious Optimism

Our strategic call is premised on the conviction that a gradual drift toward a polycentric world order is underway.

One implication of this regime shift is that it renders previous assumptions less binding.

Admittedly, there are no winners in a trade war. However, the current US-initiated tariff hikes are not widely supported, and retaliatory responses thus far have been relatively restrained. Importantly, we believe key trading partners — particularly the EU, Japan and small open economies in Asia — will work around trade barriers. A case in point is the proposed 12-member Trans-Pacific Partnership (TPP), a regional grouping that was stillborn after the US withdrawal in 2017. But that did not stop the remaining countries from ratifying a modified agreement in the following year. The upshot is that, while there are challenges to a multilateral trading system, regional and bilateral negotiations remain a viable option for countries that rely heavily on free trade. Nowhere is this more evident than in EM countries.

A corollary implication is that, paradoxically, EM inflation risk could turn out relatively manageable. It is worth noting the prevailing deflationary forces in China, in the face of persistent supply glut and a lack of progress in lifting its own domestic consumption. As the world’s second-largest economy, China’s trade linkages with the Global South have increased markedly over the past decade. While the expansion is attributed to shipments of intermediate inputs to low-cost producing countries, rising incomes will position these economies as core consumer markets for Chinese goods in future years.

As it relates to the current standoff in US trade policy, the wild card, we believe, is in financial flows rather than goods exchange. To be clear, the US dollar will likely continue to maintain its dominance as a unit of account and a medium of exchange. However, as a store of value, the outlook for the US dollar has become less certain. Should diplomatic crosswinds persist, the so-called exorbitant privilege of the US dollar could be called into question. Indeed, significant offshore holdings of front-end US Treasuries suggest some degree of rollover risk. We view the recent strength in precious metals as motivated in part by the global search for alternatives to the US dollar.

More generally, the distinction between EM and developed countries is increasingly blurred. Historically, the EM narrative has been associated with policy heterodoxy, institutional weakness, and political instability. However, these attributes are now emerging in a growing number of developed countries.

As a case in point, in the area of public debt, few, if any, governments can now risk increasing spending without any regard for bond vigilantes, as depicted by the inordinate volatility in the UK Gilts market in 2022. Oddly enough, fiscal metrics in many EM countries have stabilized or even improved, having been subject to market discipline over the years.

Risks That Remain

What are some factors that could stand in the way of EM? We may underestimate the network advantage of the US dollar. Back in 2011, US Treasuries rallied despite the country losing its AAA rating from S&P. Should global tensions escalate further, the safe-haven attribute of the greenback could reassert itself. Investor distrust in EM could remain deep-seated enough to be overridden by opportunities closer home. Given a still-uncertain geopolitical outlook amid a global slowdown, fat-tail events in EM could include sovereign defaults, official sanctions, and custodial freezes. Indeed, for an asset class that spans over 70 countries, active monitoring is of paramount importance.

Conclusion: Reappraising EM Debt

Arguably, the non-monolithic nature of the asset class favors a customized approach that fits an investor’s mandate. With EM having fallen out of favor in the past decade, current investor positioning is light. We believe the time is ripe for reappraising EM debt at this point in the global cycle. Our conviction is that the long-term investor will benefit from relative value and international diversification that EM debt offers.