Associate Portfolio Manager Ayman Ahmed discusses why you should consider emerging market debt, recent challenges to performance, and future opportunities.
Emerging Market Debt – Then, Now, and the Future
Ayman Ahmed: So overall, very tough year for EM, but I do want to impress, that there still are opportunities. We did have some bright spots as mentioned. Chinese tech, north Asia overall. You had digital tailwinds, which meant great opportunities, to put capital to work.
Rob Costello: Welcome to another episode of Away from the Noise, Thornburg Investment Management’s podcast on key investment topics, economics and market developments. I’m Rob Costello, client portfolio manager at Thornburg. We’re joined today by Ayman Ahmed, associate portfolio manager on Thornburg’s global fixed income team. Ayman’s expertise is within the emerging market debt space and today we’ll have a discussion on the opportunities for risks within that space. To give you an overview of Ayman’s background, Ayman joined Thornburg a little of a year and half ago. Prior to that, he was an assistant Portfolio Manager at Dryhouse Capital Management for five years, and before that Black River Asset Management. At both firms he focused on the emerging market debt space, with the additional function as being head of global macro. He holds a Bachelor of Science degree in finance the Carlson School of Management at the University of Minnesota and completed a continuing education program from the HEC School of Management in Paris with a focus on international economics. Tell me, do Minnesota and Paris have anything in common?
Ayman Ahmed: Honestly, not a lot. Maybe myself. I am part French. I consider myself a Minnesotan, and I’m a Francophile. maybe the Louisiana Purchase. But honestly, like, I said, not a lot. That was a great appeal for me. I was living in Minnesota at the time, so it sounded great to, to get out of the country. and enjoy another culture.
Rob Costello: Let’s talk about your area of expertise, emerging market debt. For investors, and our listeners who allocate assets to fixed income, emerging market debt is, or at least can be, or should be part of a diversified fixed income portfolio. Yet the term emerging market debt can cover so many different areas. So, for the benefit of our listeners, let’s talk about overview of the market itself. The breadth, the composition, how it compares to developed market sectors. Can you share with us your insight there?
Ayman Ahmed: Absolutely. First of all, I absolutely agree. Emerging markets should be a part of our portfolios at any given time. You can oscillate up and down the risk curve or, rating or, or duration or what have you, but there are a plethora of opportunities. First of all, we break EM into three different buckets. There’s sovereigns, corporates and local. We spend most of our time between sovereigns and corporates. So, I’ll break that down for you today. we have, hard currency debt, which is US Dollar, Euro, British pound, etc. It’s, $1.4 trillion in size. That’s about doubled in the last, 10 years. There’s three reasons why this market specifically exists. liquidity, you can always tap, the multilateral market. it’s cheaper and longer financing, traditionally, if you’re financing in US Dollar, other hard currencies, it’s lower coupon lower yield, and typically longer duration than maybe local bank financing. That might be, one year or shorter. another reason is, you have a short dollar position. that’s a, because of a current account deficit in most, most of the time, which means, basically, you’re sending more dollars out than you’re getting in, so you have to plug that gap with issuance. That market is broken down into five different regions. Africa, Asia, Europe, Middle East and Latin America. Latin America being the largest at 32 percent. If you break it down by quality, it’s roughly a 50/50 spilt between IG and high yield. Investment grade and high yield. And the next, is the corporate bucket which is where we spend most of our time and where most of our allocation is towards. It’s nearly twice the size of the sovereign market, around $3 trillion. Financials are the largest sector at 31 percent. Oil and gas next at 13. Utilities, industrials and consumer, telco is all, are all around 10 percent, and then lastly, you have, real estate which is, just south of 5 percent at 4.6. I find that a little bit comical because we spent so much time this year talking about, Chinese real estate, yet it is such as small sliver of the overall pie. That quality breakdown is roughly 55 percent IG and 45 percent high yield. and so next, I just really wanted to look at it apples to apples between EM versus DM. I think this is what most people care about, the why, the why we invest in EM. And it’s pretty straight forward. you’re gonna get between 50 and 100 basis points of pickup. In EM versus DM, and it’s even more attractive when you keep it short, because EM curves are rather flat versus, DM and US curves are rather, steep. so just to give an example behind that, you can buy EM 1 to 2‑year paper between 100 and 125 basis point spread whereas you would only be getting between 25 and 30 basis points on the US side. The only way, in an investment grade in the US that you’re gonna get, spreads between 100 and 125 basis points is the 8- to 10‑year bucket. So, you have to take down a lot more duration, which means you have a lot more core rate risk.
Rob Costello: Let’s look back on 2021. It was a year where emerging markets faced a number of headwinds despite the optimism on a global growth rebound and the rollout of COVID-19 vaccines. What were the challenges in EM last year and what were some of the bright spots?
Ayman Ahmed: You are absolutely right, 2021, was most definitely difficult. It is the first time we’ve really seen risk around state inflation. That’s because the supply side shocks that created deterioration basically in growth and at the same time pushed the, the input costs or the costs of good higher. This was definitely represented in the performance of EM assets last year. We saw EM equities down nearly 10 percent. EMFX 8 ½. EM local around 8 and EM hard currency corporates around 3 percent. Thankfully, that’s where we spend most of our time. with those challenges, there were a lot of idiosyncratic, issues at work, so in Turkey, you had hyperinflation currency selloff and political risk. You saw the currency off 122 percent at one point. Now, it’s back to about 85 percent. weaker year over year. in Brazil, you had political risk and fiscal, and fiscal pressure. That means they had to hike 725 basis points last year. In Ukraine and Russia, still an ongoing issue today. You saw Ukrainian bonds, 500 basis points wider and Russian corporates between 100 and 200 basis points wider. That’s a combination of military and political risks. Columbia was a fallen angel which meant it went from investment grade to high yield. that’s on exodus of investors. In Chile and Peru, we had a lot of leftist pressures. Which made it, incredibly difficult place to put money to work, and then in Chinese real estate, as mentioned, it was a deluge. We saw bonds go from above par to 20 cents and we still have, material risks around that sector today. So overall, very tough year for EM, but I do want to impress, that there still are opportunities. We did have some bright spots as mentioned. Chinese tech, north Asia overall. You had digital tailwinds, which which meant great opportunities, to put capital to work. It meant a robust balance sheets and net cash positions. Mexico had a really good year because, they are mostly an export economy; 70 percent of the exports go to the US, and we saw a lot of fiscal austerity. Sub-Saharan Africa is made up of oil and gas exporters, coffee exporters, precious metals. All of those did exceptionally well last year. And then on the local side, we had good opportunities, in places like Egypt and Indo. They had low historical inflation which was, you know, quite surprising given what was happening globally, so which meant robust real rate positions and then we also had no geopolitical or political, issues rise in either of those jurisdictions last year, which made for quite a good backdrop for fixed income returns.
Rob Costello: Within the United States, we’re experiencing, as you know, an elevated level of inflation that is proving to be more relentless than many investors and indeed the federal reserve initially expected. In response the Fed has pushed forward rather aggressively its forecast for rate hikes and has even begun a reduction of the balance sheet, AKA, quantitative tightening. Historically, Fed hiking cycles have been a cyclical head win for EM. Do we expect the same now?
Ayman Ahmed: Absolutely. I mean, it’s not a straightforward answer. I would say yes and no. So first of all, the backdrop for EM is a little bit difficult, as we discussed. There are cost-side pressures. There’s the idea of state inflation. There was a lot of fiscal spending going into this, so you might see fiscal tightening as well, but I do want to, illuminate the fact that has been ahead of the curve a little bit. As mentioned, we did see 725 basis points of hiking out of Brazil. We saw 425 basis points of hiking out of Russia. We saw 350 basis points of hiking out of Chile and the Czech Republic. We saw 300 basis points of hiking out of, Peru and Poland. 200 basis points out of Hungary. So, as you can see, I mean, there has been a lot of hiking already in play whereas, you know, the developed markets as a whole have been on hold, so we’re a little it ahead of the curve therefore there is a better real rates position going into this. Also, we are starting to see growth surprises out of EM, that are accelerating past DM which means there are still growth opportunities, and a lot of that has to do with the fact that EM is largely exposed to China’s growth cycle. China is actually easing on the fiscal and the monetary side, which means they’re gonna continue to digest a lot of the global goods that are coming out of emerging markets. On top of that, we are coming into cheap valuations in EM overall. That is local and external. That is because of the selloff that I did mention last year, so we are also coming into a situation where spreads are not at all time tights, so I think that also creates a nice backdrop for EM overall. And yeah, there’s a differentiation play. So, I think we are trying to, cozy ourselves up to economies that can, maintain beta to the to the global growth play, but at the same time, our able to sidestep the move up in core rates.
Rob Costello: Given your thoughts so far, how are we positioning ourselves within EM debt in our fixed income funds. What do we like and what are we avoiding?
Ayman Ahmed: Right, so in lieu of the Fed, in lieu of pricing and position, etc. we are taking a differentiating approach for 2022. our positioning overall is between 5 and 8 percent across our funds. I would say that’s pretty much middle of the road. Not super bearish, not super bullish. and that’s for the four, different reasons that we did mention. the proactive hiking, the Chinese growth. The, the underweight positioning and the growth surprises that we are seeing in EM overall. So, with that, there’s a few different buckets that we’re putting money to work in. Commodity exporters, whether that’s oil and gas, precious metals, like gold and platinum. textiles, and basic goods. We are also looking at net cash corporates, like, tech companies and commodity names that have been able to deleverage balance sheets in 2020 and 2021. Overall, we’re looking at shorter duration. as mentioned, we actually get a bigger pickup in EM if we are shorter relative to DM, and we’re also looking at floaters, that way, they can just pass through, core rate hiking. We’re looking at defensive in EM, so we’re not looking to partner too much with, domestic demand improvements in EM. We think overall it’s not going to be that great this year, so we’re looking at utilities, telcos, bottlers, and basic goods. and then on the local side, we continue to look at real rate local positions, so countries that continue to have low inflation, like we experienced last year in Egypt and Indonesia, and then also places that have been proactively hiking, like in Brazil, South Africa and Russia.
Rob Costello: Ayman, ESG considerations are playing an increasingly important role in client’s portfolios as you know. How do you see ESG playing out in emerging markets today?
Ayman Ahmed: Yeah, I think the asset class itself is growing. I think there is a broad awareness, from investors that we need to invest sustainably. I think most importantly, we’re not giving up a lot of yield or coupon by investing in EM. At one point, there was such a heavy demand for green bonds that it was, it was, pricing 15, 15 basis points tighter relative to just, what I would call normal bonds. We’ve seen that move off and it’s closer to zero to five basis points, so again, we’re not giving, up much to invest in that way, but we are very happy to do it. We like to see companies that are investing in the future. That means investing in sustainable programs in recyclables, in green energy. Their reducing their waste overall. a lot of them are tied to the UN sustainable program of being carbon neutral by 2050 and reducing, their carbon footprint by about 30 percent by 2030. The opportunities itself continues to expand. We continue to see green companies, so renewable companies themselves pop up and start to issue. We continue to see green programs come out of, historically, carbon heavy industries like pet chems, oil and gas and bottlers. And so yeah, I think the tide is there. I think that we will continue to give access to green companies and sustainable companies, and it lines heavily with what we’re doing here at Thornburg, with corporate sustainability and ESG across our investment platforms.
Rob Costello: Ayman here’s a question I’ve pondered and maybe investors have too, but do emerging market ever countries truly emerge?
Ayman Ahmed: I hope not. You would see a lot of investors sad to see countries like, Korea China, move out of our index. There are a lot of reasons why you could say they have emerged. If you’ve visited Seoul for example, you would say it’s quite the developed country itself, but I would say no, they don’t often emerge, and it’s not necessarily in everyone’s benefit that they do.
Rob Costello: Thank you, Ayman, for your time today.
Ayman Ahmed: Thank you, Rob.
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