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by  L.BensafiP.Kurdyavko Nov 20, 2020

In this video, Polina Kurdyavko, Partner, Senior Portfolio Manager & Head of Emerging Market Debt, BlueBay Asset Management LLP and Laurence Bensafi, Senior Portfolio Manager & Deputy Head of Emerging Markets Equity, RBC Global Asset Management (UK) Limited, share their perspective on the outcome of the election and what it means for emerging markets.

Watch time: 48 minutes 11 seconds

View transcript

Hello. Thank you very much for joining us. My name is Mike Higgins. I’m really happy to be here today in the midst of such a remarkable period, not just with respect to the capital markets and recent developments on the COVID vaccine front, but of course the U.S. election, which is what we’ll dig into in terms of the outlook for emerging market equities and emerging market debt.

Before I jump in and introduce our panelists for today’s discussion, I thought we could start with a polling question just to get the audience’s view on emerging markets going forward. So our first polling question today is, with the dust settling on the U.S. election, how do you feel about the prospects for emerging markets going forward? Are they improving, declining, or no change?

As the results get tabulated, I’d like to take this opportunity to introduce our panelists for today’s webcast. Both based in London, England. First is Laurence Bensafi, Deputy Head of Emerging Market Equities and Senior Portfolio Manager with RBC Global Asset Management. I’d also like to welcome Polina Kurdyavko, Head of Emerging Market Debt and Senior Portfolio Manager with BlueBay Asset Management.

Laurence, Polina, thank you both very much for being with us here today.

As the poll shows, we’re getting a mixed review. Well actually, no. It’s 100% improving. So the prospects from the audience are looking pretty good for emerging markets going forward. So with that, perhaps I could ask each of you to kick things off with your thoughts on this in the context of the U.S. election. So the pros and cons for EM going forward against the backdrop of a Biden victory versus a Trump win.

Laurence, perhaps we can start with you.

Yeah. Thanks, Mike.

Laurence Bensafi

Senior Portfolio Manager & Deputy Head of Emerging Markets Equity,

RBC Global Asset Management (UK) Limited

So I would first say that the outcome of the U.S. elections in terms of who was going to win between Biden and Trump was not really a huge deal for emerging market equities. What was really important was to have a clear and timely winner to avoid instability in the world’s biggest economy. Asset class doesn’t like uncertainties, and what was noted was to move on from the elections. That said, on balance, the win of Mr. Biden is slightly positive, I would say, for emerging markets. We could expect a slightly better relationship with the world, a less controversial tone, maybe less sanctions, a lot more dialogue with the world.

The relationship with Europe should improve going forward, and President-elect Biden could also try to revive the U.S. economy using bigger stimulus. That would be positive for emerging market in terms of the exposure to commodities. And that also could keep the U.S. dollar on the weaker side, which is always a positive for emerging market equities.

On the other hand, for sure Mr. Biden will remain to be quite tough on China and other countries such as Russia, so that could weight a little bit on our markets. And he may not be as business friendly as Mr. Trump, and that also could be a negative for equities going forward.

That’s it for me, Mike.

Great. Thank you, and we’ll expand more on some of those in a few moments. Polina, is there anything you’d like to add?

I would agree with Laurence that in general either outcome would not be a bad one for emerging markets as Trump represented more of a status quo while Biden represents more probablization for pro-growth policies, which would be beneficial for emerging markets.

Polina Kurdyavko

Partner, Senior Portfolio Manager & Head of Emerging Market Debt, BlueBay Asset Management, LLP

I think with Biden at the helm there are two factors have a tailwind effect on emerging markets.

One is a positive, supportive, accommodative stance of the Fed. For the next three years rates are likely to remain low. Secondly, is more fiscal stimulus, which again, should boost growth and, therefore, should support emerging markets.

I would say the biggest winner from the Biden presidency could be emerging market local currency asset class. Local currency have underperformed for the good part of the last 10 years, and we feel that that could be turning as Biden policy mix could mean weaker dollar and hence stronger currencies.

Last, but not least, I would say that while I agree with Laurence that the sanction risk is not out of the way and we will continue, potentially, to see more or harsher stance with certain companies and perhaps countries such as Russia, unlike Trump, I feel confident that we’re likely to see less Twitters and less headline risk. And, therefore, more broadly on a day-to-day basis, we feel that the volatility of the market could be reduced as a result.

I agree. Thanks, Polina, and we’ll expand more on some of your remarks in the sort of back half of our webcast.

So let’s shift gears here and dig a little deeper into emerging market equities more specifically. Laurence, before I turn it back over to you, let’s go to the polls again and ask the audience to weigh in with their thoughts on this question.

The question is, if we look at the performance of emerging market equities going forward, how do you think EM equities are going to perform relative to developed market equities in the next 12 to 24 months? Do you believe emerging market equities will outperform developed market equities? Or do you think emerging market equities will underperform developed market equities?

And, Laurence, while we wait for the results to roll in on the poll, just to set up your remarks, EM equities, like most asset classes, have rallied sharply off the March lows. So following the draw-down of over 20% between February and March, indices have recovered over 40% since. And now if you look at a one-year basis the index is up over 10%. So when we think about the sustainability of this rally, there’s so many drivers in play that would be great to get your thoughts on. So needless to say, lots to cover off.

Now if we look back at the poll we can see that now so far 100% of respondents believe that EM is going to outperform developed markets in the coming 12 to 24 months. And now we have 75% outperform. So clearly, the audience believes that the prospects, tailwinds are there in favour of emerging market equities. So maybe against that backdrop, I’ll turn it over to you for your thoughts.

Larence Bensafi: Yeah. Thanks, Mike. And definitely I think things are looking much better for emerging markets compared to developed market over the next few years. So if we can bring the first of my slides, you would see that the situation has been very different over the past few years.

EM vs DM long-term performance

Long cycles of relative performance

You can see on that chart the relative performance of emerging market versus developed markets looking a long period of time. And you can see that basically there are long cycles of under- and outperformance. So we are just, hopefully, at the end of a 10-year underperformance period. Just before that, we had a very nice long period of outperformance. So why did we have this long underperformance? It’s basically since the global financial crisis, we never completely recovered. Even though we didn’t have a global recession since then, it’s been a very difficult period for emerging markets with a lot of our countries going into recession.

And towards the end, over the last few years, we were expecting a recession at some point. It was postponed a few times by some action, notably from the U.S. that was kind of artificially keeping growths alive and central banks also globally really keeping rates really low. But now we feel like we are in a reset period, and typically when you have a big global recession like that, that’s when things change.

So the two main drivers for better performance of emerging markets compared to developed market is, first, a weak dollar; and the second one is a better economic performance. So if you look at the slide on the next page, you can see that indeed, for the past 10 years, the differential of growth between EM and DM has been narrowing.

EM/DM GDP growth

Growth differential expected to wide in EM’s favour

Larence Bensafi: So obviously emerging market always grows faster than developed markets, but this differential has been becoming narrower and narrower.

Now, during the pandemic, we can see the strengths of emerging markets. You can see that emerging market economy growth is going to be not as bad by a long mile compared to developed market. And then in the coming years, emerging market will appear stronger compared to developed market. There’s been less heat by the pandemic for some of the countries that have been hardly hit, such as China, Korea, or Taiwan. And for some other countries, they just could not afford to be hit so they didn’t do really as much lockdown as we’ve seen in our country. I’m thinking bad countries such as India, Brazil, or South Africa. So this differential of GDP growth is going to be a real beneficiary for the performance of emerging markets versus developed market going forward.

If we go to the next slide, another support for asset class to do better is just the valuation differential.

EM equities valuations

EM trades at a significant discount to DM, despite recent strength

Larence Bensafi: Because we’ve been underperforming for 10 years, the valuation of emerging market compared to developed market is very attractive. We trade at about a 30% discount. This is really one of the biggest discounts we have ever seen. We expect more at about a 10% discount. So really emerging markets are cheap compared to developed market.

Having said that, looking on the chart on the right, it’s a point I want to make just to—we are very positive, but just to notice that with a good performance of equity market this year, emerging markets are not as cheap as they used to be. They trade at around just below two times price to book, which actually kind of a long-term average. And at that level of valuation, really, I would say the market can go both ways. We could well see a correction if the recovery we’re expecting for next year doesn’t materialize. We can also obviously go higher in terms of valuation, but a little word of caution that valuation on relative are they attractive, but on absolutes I would say they are more like kind of average level of valuation.

So why is that important? Because I think going forward we really need to focus, I think, on laggards. You know, the country, the sector this time have been underperforming. That’s where probably we’re going to see better returns.

So if we move to the next slide.

EM equities performance

China has been the standout performer this year

I thought it was a really interesting slide that people don’t always realize is that emerging markets have been performing in line with developed market this year but this is really because of China. China has been the standout performer in emerging market. Like the best performer around on one, three, five years view. And it’s interesting because China for a long time was actually a country that people didn’t want to invest in. It was full of detrimental prices, low quality.

So it was high-growth market in terms of economy growth, but the stock market didn’t do anything for a while. And it’s completely transformed into a few year. And the reason it did so well this year is first, of course, because they did very well with the pandemic in terms of dealing with [data], not being hardly affected. But it’s more than that. It’s that the stock market has been completely transformed and now the biggest players in the market by far are what we call now the COVID winners but like the new economy stocks or the E-commerce giants or the gaming companies. They now make up the majority of the market, and obviously this year they’ve been doing extremely well.

So in the meantime, a lot of our countries have actually done very poorly and we’re going to go through some of them, such as Brazil or Mexico when we see some opportunities. So it’s quite important to note that there’s been a huge difference of performance between some winners and losers also in emerging markets.

So if we look at the next slide you can see very similar results in terms of performance of sectors, especially over 12 months.

EM sector performance

3 and 12 months

So over three months, we’re starting to see a little bit of recovery from the losers but, you know, sectors such as consumer discretionary when you’re going to find the E-commerce names, health care, communication services, have been extremely strong. And on the other hand, the losers have been financials. It’s really a terrible environment for them. Low-interest rates, asset quality deteriorating, sectors such as utilities, real estate, energy have been doing very, very poorly. But you can see already that on a three-month basis as the outlook is starting to—I guess people have been starting to focus a little bit more on 2021 and the recovery. Obviously, all the news around the vaccines has been positive. Now it seems that the second wave in Europe is easing, et cetera. You start to see already the beginning of a rotation and the financials, for instance, are starting to perform well.

So that’s an area really where we feel there’s a lot of potential for performance and it remains a big sector if it’s not anymore the biggest sector in emerge market. Still, it’s in a big sector.

So on the next page, currency’s also extremely important for emerging market.

EM currency valuations

EM currencies looks cheap relative to their own history and the U.S. dollar

As a reminder, when you invest in our products you take full exposure to local currency and a lot of emerging market currencies are very cheap right now. It’s very much correlated with the equity market. So the most expensive currencies are going to be the countries that have been doing the best and are less risky. So you’re going to find China, Taiwan, Korea, Philippines. On the other hand, the riskier countries are going to show cheap currency. And some of the currencies are the cheapest they’ve been in 10 years and some are the most expensive they’ve been in 10 years just to show you the extreme we’ve been facing this year.

In terms of interesting currency, we find the Chilean peso is interesting at the moment. A country that we find quite attractive and we feel has been—should be a rebound in the near term. Another point to make and I’ll mention it is the U.S. dollar. U.S. dollar is a very important driver for emerging market currency for a different reason—emerging market performance for a different reason. And the U.S. dollar appears on that chart quite overvalued and we believe really that it should not remain the case in a period of recovery and in a period of large deficits in U.S. So that’s another important point to consider where the dollar is going to go in the coming years.

On the next slide now, valuations.

EM country and sector valuations

Divergence between COVID-19 winners and losers

So you can see the valuations in terms of country and sector and the range of valuation over the past 20 years. And again, you can see that similarly to the currencies, some countries and some sectors are the cheapest they’ve ever been and some are the most expensive they’ve ever been. So again, rotation will happen in the coming quarters and years.

So in terms of countries, I would highlight Mexico and Chile look really attractive. The country that look expensive is Taiwan. It’s a really, really interesting country with a big exposure to the technology sector, really world-class companies in that country, but valuation seems stretch at the moment so we’ll be careful. China also mentioning after their strong performance doesn’t look very attractive.

When it comes to sectors, as I mentioned, financial is really the one where we find the most opportunities. First, the banks. They’re in a much better situation than they were before the global financial crisis. Obviously, regulation has been stricter for the banks. Capital requirements are also much more stricter and they’re in general in a much better position. They have been more prudent as well, and we feel like the very low valuation is not really justified considering that the situation should improve from next year. Obviously, if it doesn’t, it’s a different story. But where it’s priced right now is basically no improvement from the current situation which seems quite unlikely.

Energy’s also very attractive. It’s a little bit more difficult because it’s difficult really. It really depends a lot on the view on the oil price which is always difficult to form. So even though those names look very attractive, it could remain cheap for longer or at least very volatile. So maybe a sector that is interesting but where we see more volatility going forward.

Finally, the next slide on size.

EM style performance

Relative style performance has accelerated this year

It’s been an incredible year again like everywhere of extreme in emerging market. So the top line shows you really the performance of the growth style that has been absolutely the winner this year, and the line at the bottom is the value style with where you’re going to find the financials and the cyclicals, and obviously on a growth side, you’re going to find the COVID winners. This is the biggest outperformance of growth versus value we’ve ever seen in emerging markets. As I mention, over the past few weeks, few months, we’ve started to see the beginning of a rotation, and it’s actually been—I mean it’s very beginning as you can see. You can see the lines hardly moving in another direction. But we believe that those lines will continue to move and the gap will continue to close.

Again, obviously, if we see a recovery in 2021 and the pandemic is under control, that the vaccines are deployed and are effective. That’s again, really an opportunity for investors to focus on, for instance, the value names.

Another area that is very interesting is the quality names. The quality names have been also out of favour. Investors really focused on shortened growth even if it was not profitable growth and I think, again, in a different environment an investor would focus back again onto quality names that we find are quite attractively valued as well.

EM brands: Growth drivers

Rising incomes and a young demographic are driving discretionary spending

So the following slide are just going to give really a couple of minutes on some interesting theme we’ve been seeing. Obviously, E-commerce has been quite important in emerging market, but apart from China and Korea, it was very small and it’s something always we considered as in 10 years this is going to become big in emerging markets. With the pandemic it has accelerated to an unbelievable level. When we talk to companies, whether it’s in Brazil, South Africa, what they tell us is that in six months they saw what they were expecting to happen in seven years. So this is really, really impressive. And what we’re going to see, we’re going to see really a huge growth in this area.

Why is that important? It’s because in emerging markets, we are really entering an area where consumption is really growing really fast because the majority of emerging market countries are now reaching the GDP per capita level of $10,000, which is really when domestic consumption really increases massively. And because now the population is really moving away from the Baby Boomer and the Generation X, and going into Millennials, those are the people that really want to consume online. They have different habits. So you’ve got the combination of this younger population consuming, more people consuming, and this is going to all happen online. So that’s something again that’s been different that accelerated massively this year for emerging markets.

EM brands: Trends

Changing consumption trends driven by a young EM demographic

So if you move to the next slide, we can see that we’re going to have really a large increase in many countries for the coming years when it comes to E-commerce.

And finally, the last point I wanted to make was on China and the U.S. So—on the next slide.

U.S./ China relations

Are we entering a cold war?

Clearly the relationship between the U.S. and China is going to change, I think, at the margin. The tone is going to change. But the reality is the Biden administration is not going to be really softer on China. It’s really both sides in the U.S. that have been really willing to face China and to challenge China for different reasons. But this is not going to go away.

Now, our view is that this is not necessarily a major deal for China. As I mentioned before, China is best performer emerging market country for the past few years and the trade war between the U.S. and China had started for now almost three years. So clearly this hasn’t been a major issue for China. China has probably reached a plateau when it comes to export to the world. You can see that on the chart on the right. China’s focus is more on domestic consumption, and when it comes to export to quality high value-added export. And what China is focusing more on right now is not to be dependent on imports, especially, again, for technology products. So what the trade war and the confrontation with the U.S. is probably going to do is that China is accelerating its quest into being more independent from the West, in particular when it comes to importing technology products such as semiconductors, for instance, which it imports massively at the moment.

So if you move to the next slide, actually you can see that a negative could be more for the West than for China in that relationship that is deteriorating.

EM brands: COVID-19 impact

Increasingly nationalistic approach to local brands.

What we’ve seen over the past few months and few years is that consumers in China are going more towards local brands and the perception of foreign brands is really turning quite negative. So this is very positive for China brands, local brands that are going to grow massively and it’s quite negative for European, American brands that have enjoyed really exports to the biggest country in the world when it comes to consumption and population. So that’s something that we need to keep in mind and look at closely. I’m sure Mr. Biden is going to be aware of that. And as I said, that’s going to be important development going forward between the U.S. and China.

And I’m done. I’m going to hand over back to Mike. Thank you.

Great. Thanks, Laurence.

So a notable divergence in valuations, an attractive FX backdrop, and increasingly an environment of winners and losers with an eye on trade. So thanks very much for your comments.

Okay. Polina, let’s shift gears in to emerging market debt.

And will kick this off with another polling question for our audience. And this one is related to the evolution of emerging market debt over the last two decades. And the question is, if we go back to the mid-1990s, and look at the J.P. Morgan Emerging Market Bond Index, less than 5% of the index was rated investment grade. What percentage of that index is rated investment grade today? And the responses are: A 9%; B23%; C 38%; or D 56%.

Well, with the results rolling in, quick reminder that the J.P. Morgan EM Bond Index, which tracks EM sovereign debt, was established back in the early 1990s, while the EM Corporate Index only dates back to 2007. And coincidentally, Polina, you were one of the few dedicated EM corporate debt investors at the time and provided input to J.P. Morgan on the development of that benchmark.

But back to our poll, the percentage of EM sovereign debt rated investment grade is now actually 56%. And so far 100% of the audience guessed that correctly. Also, by the way, if we looked at the Emerging Market Corporate Debt Index, the percentage of IG rated debt is even higher. It’s 58%.

So, Polina, the EM bond market has clearly evolved dramatically during your time covering this asset class. Please walk us through your thoughts on emerging market debt going forward.

The EM credit landscape

Than you, Michael. And you’re absolutely correct. It has been a very interesting journey over the last 20 to 30 years for the asset class. And as you can see from this slide in the presentation, most investors are aware that the asset class is growing. And it is diverse with over 70 countries representing the index because the index criteria is geographical, not GDP per capita based. So effectively away from North America, and Western Europe, Australia, and Japan, every other country is considered emerging markets.

But I think what many investors don’t appreciate is improvement in the quality of the asset class. Today the combined hard currency [indiscernible] eliminated segment of the emerging market fixed income is over $3 trillion. It’s much larger than the size of the U.S. high-yield market. It continues to be one of the fastest growing asset classes out there. And of course with growth we see an improvement in liquidity and increase in clients’ allocations.

But I would say that one aspect of it, which still takes investors by surprise, is the credit quality. In fact, through the pandemic, the average rating of the sovereign index has increased to an average investment grade from being double B-plus. This is because with the lower risk tolerance for risky names, investors demand more investment grade issuance, and naturally it grows and hence the average composition of the asset class improves as a result.

On the hard currency corporate index it has been investment grade for a long period of time right now, even though a lot of investors perceive that as more risky than the sovereign debt. Yet if you look at past performance, it delivers similar volatility to investment grade rated assets in developed markets but, of course, higher returns given the starting point in the carry.

On the local currency markets, again we’re seeing a similar dynamic.

The EM local market landscape

On the next slide you can see that the asset class, despite the fact that the local currency has not performed very well over the last 10 years, the asset class continued to grow as more domestic pension funds, insurance companies, are starting to allocate to domestic funding. And I think one of the key change in the asset class over the last 20 years has been increased reliance of the companies and countries on funding locally. Which is why, if you think about the total emerging market pie, as you can see from the page in the presentation, local currency funding accounts for over $18 trillion, which is much larger than the size of hard currency funding. And of course as the local currency funding grows, the vulnerability of emerging market corporates and sovereign to the currency volatility also reduces because you don’t have the currency mismatch.

US election and EM

If we look at the next slide in the presentation, we started with a question on U.S elections this forum, and I believe both Laurence and I have a similar outlook on the results of the election. In a nutshell, they’re not negative, but the magnitude of the positivity really and the performance of emerging market countries could be more driven by individual events within certain countries. And then when we talk about the credit, ability of the countries to improve their fiscal stance in the environment of lower growth rather than the macro framework. Again, be it a very different stance in the Fed policies which, of course, always matters for emerging markets, or aggressive moves from the U.S., which would escalate the tensions between the emerging markets and the U.S..

Looking at the next slide in the presentation, I would like to spend a few moments talking about what has been the recovery so far post-COVID in economic terms?

V shaped recovery?

What does it mean in terms of the opportunity set and hard-currency debt, corporates, local currency debt? What are the key risks for the asset class over the next 12 months? And what, perhaps, subjects are gaining a lot more importance in emerging markets which might not be in the focus of investors.

So firstly, starting with growth. As you can see on the page in front of you, page 17, the PMI dynamics in emerging market has shown almost a V-shaped recovery. In fact, as Laurence has mentioned, China performed quite strongly. And again, this was not only performance in the equity markets. We know that Asia, and China in particular were among the best in addressing the pandemic and hence have led the V-shaped recovery in the region. But in other countries, in other regions, if you were less fortunate from the growth perspective, we still have seen an improvement in the economic data quite fastly after the pandemic broke.

And if you look at the next slide, you’ve seen a different version of that slide in Laurence’s presentation.

Forecasted growth recovery in EM should outpace recovery in DM in our view

The gap between the growth in emerging markets and the developed market has widened this year. In fact, I would note that 25% of emerging market countries actually delivering positive GDP growth this year, which cannot be said for any emerging market country—sorry, any developed market country.

And then the literal question becomes well if the PMI are recovering and GDP is growth is quite healthy, what is happening on the debt side? Are we actually funding that recovery through a lot more debt? Which of course, as a debt investor, would be one of the key questions for asking. And if you look at the page 19 of the presentation, which is the next page in the slide deck, you would note that actually, even though the debt has increased in emerging markets, the magnitude of the increase has been smaller than it has been in developed markets.

DM governments are adding more debt than EM

In emerging markets, the debt has increased by 9 percentage points of GDP, whereas in developed markets that increase has been over 22% in GDP. And if you look at the aggregate numbers, on average, emerging market debt to GDP is around 61%, which is not bringing the worry of solvency of emerging markets given they are overleveraging. And, of course, it is less than have of the debt stock that is currently in developed markets.

And I think one of the features of this crisis compared to the last crisis that we’ve seen is that we’re likely to come out of this crisis with more debt and less growth. And naturally, it’s a pretty difficult environment for any company or country to operate. And if that were the case, what is the best way to allocate your investments? What is the best way to position yourself into that environment?

If you look at the next slide in the presentation, we summarize some of the key themes for us in hard currency credit.

Wide spectrum of opportunities across EM credit

I would start by saying that in the environment of lower growth and uncertainty in the shape of the recovery, safe carry is investor’s number one priority. So naturally, we think that investors would look for places where they can deliver, receive that safe carry. And one of the areas which continues to be attractive is investment-grade rated assets in emerging markets. As Mike has pointed out, majority of EM assets in the hard currency space and local currency assets are rated investment-grade. In a hard currencies space you don’t have to take the FX risk, per se, but you’re still getting high-yield-like returns for investment-grade rated companies and countries.

So here we continue to be overweight the space. We like some of the exposure that we have in Asia and Middle East. Asia in the context of growth and the pace of the recovery, Middle East as a region which actually has been relatively less affected by COVID compared to other regions.

And I would also note more broadly when we think about economic recovery and COVID, we’ve seen a disconnect in emerging markets between the ability of emerging market countries to manage the COVID pandemic and the pace of recovery. As you might know, a lot of emerging market countries did not go into the second lockdown as we have done or a lot of European economies have done.

And just having a conversation, a group conversation with President Putin about three weeks ago, when we ask him the same question, why are you not implementing their second lockdown? What is your view on the COVID pandemic? The answer was, we feel that it will be too disruptive for the economy if we were to change the rules on the regular basis. And, therefore, we’re sticking to the implemented rules and restrictions that were implemented at the beginning of the year, but we want to give stability for the businesses so they can restart the operations.

Of course, we are not to judge whether these measures are right or wrong, but what we can observe is that when it comes to economic data, we’re continuing to see recovery in economic data. And a lot of emerging market sovereigns are actually becoming more orthodox. Even places like Turkey, which is known as a very unorthodox country when it comes to monetary policy, finally having faced the crisis started to do the right thing by hiking rates. South Africa started to address corruption, which has been the Achilles heel of the country for over 50 years.

So in general, while we’re not very optimistic on growth, we feel that investment in these investment-grade assets is a safe carry proposition which could be quite appealing. And if we see some of the countries doing the right thing, that will further compress the spreads that remain elevated.

On the other side of the barbell, we have dislocated or distressed credits. Again, in the sovereign space, unlike corporates when the countries have to reprofile their debt, they do not leave the index and the liquidity of those countries and the debt issuance does not decrease compared to the countries that continue servicing their debt. And, therefore, sometimes we can identify a number of opportunities that trade at $0.20, $0.30, $0.40 on the dollar where actually within the 6 to 12 months you could potentially even could double your money as you reprofile the debt. Because when you’ve seen the previous slide on the leverage in the emerging markets, you would note that the problem that emerging market countries have had is not the problem of solvency because, as you can see in the slide below, the debt levels are quite low.

DM government are adding more debt than EM

Often it can be a problem of liquidity, which can be easier fixed than the problem of solvency, if you will, when your balance sheet is overlevered. So certain opportunities we also find appealing here.

On the corporate side, coming back to the slide on page 20, we feel that the default rate will remain quite low.

Wide spectrum of opportunities across EM credit

In fact, the default rate in emerging market high-yield segment year to date has been more than three times lower than default rate in similar rate of credits in the U.S. It’s quite an unprecedented difference. And the recoveries in emerging market corporates have given more than doubled their recoveries in similar default of credits in the U.S..

Quite an interesting stat, and I will talk about in a minute or so why that has been the case. But more broadly, as we expect the default rates in the corporates to remain low, we feel that even double B and certainly single B credits can offer that safe carry for investors in the corporate universe, which has outperformed sovereign universe year to date.

What are the risks? Let’s have a look at the next page, page 21.

Sovereign 12m maturities appear manageable in our view

One of the risk is liquidity. Access to liquidity is key, and even though emerging markets continue to grow we want to make sure that there are lenders of last resort that can support the countries that need access to liquidity.

The good news is that lenders still in place. It’s IMF. Twenty-five percent of IMF lending can be available to emerging markets if you measure it as a percentage of total emerging market debt or over $1 trillion. That is plenty for emerging markets. The key is not the amount that is available, the key is how you access that liquidity. And to access that liquidity you have to take an orthodox policy mix which, to us, would be the key driver of performance of emerging markets in the next 12 years. Policy orthodoxy will be rewarded with very strong performance. Policy unorthodoxy and lack of transparency will not be tolerated. That has become very clear through the course of this year and we think will continue to be the theme going forward.

On the next slide, page 22, you can see the leverage on the left-hand side in emerging markets versus developed markets and also the default dynamics and the recovery dynamics that I mentioned earlier.

EM corporates in comparatively strong position relative to DM corporate

Again, this time around emerging markets have surprised, I would say have had the biggest surprise in the last 20 years in terms of their deviation from developed markets, and a lot of it came from the fact that they have high-quality buyers. There’s only the one sector that is really exposed to COVID which is airlines, and that sector accounts for less than 0.5% of the index that we invest in.

Naturally, a lot of companies were able to pass through this crisis, and the oil price collapse five years ago has helped the asset class to focus on deleveraging and cash flow generation, and we would expect that to be the case going forward.

And of course, last but not least, is FX valuations on the next slide on page 23, and our expectations are there’ll be four months of local currency markets.

EM local markets – FX valuations look attractive

I mentioned that local currency could be the biggest outperformer for the next cycle and I would take it even a five- to ten-year cycle having seen how poorly they’ve done over the last ten years. But the key would really lie in orthodox policy mix from emerging markets and, of course, lack of disruption when it comes from sanctions from the developed world which we feel would be the case going forward.

Now, at the very end—I know I have one minute left. I wanted to touch upon one subject which has become a buzzword; the three letters E-S-G in the world of investors, but I feel that has not been addressed enough on the emerging market side.

Integrating ESG factors in EM long before ESG became a ‘buzz’ word!

If you look at the next page, page 24, we talk about our approach to ESG in emerging markets. We have focused on the ESG part of our analysis long before ESG has become a buzzword, but I feel that there’s one key distinction when we talk about ESG in emerging markets. When access to capital is abundant, the willingness of countries and companies to improve their ESG metrics is relatively low. When the access to capital is restricted, the willingness to engage is very high. And what we have seen time and again—and this is another example. This year is another example of that. When access to capital becomes more restrictive, companies and countries are more willing to improve their metrics and we can put our conditions when it comes to changing the Board of Directors, changing certain governance practices, improving environmental standards. And just on the latter point, we know that environmental changes are very hard to introduce. And if you look at page 25, the last page in my presentation, we talk a little bit about the deforestation risk in the Amazon forest.

Engagement with a Latin American sovereign over deforestation concerns

In the past, that was very much a topic for let’s say Greenpeace, for the lack of a better word, and was not really targeted by credit investors. However, as part of the limited access to capital, we are now in a position to force the governments to act on issues that we consider quite close to our heart. And in fact, we have engaged with the Brazilian government through the course of this year asking them to implement the moratorium on the forest fires given the increased risk of deforestation and, in fact, together with cooperation with European parliament and the government of Brazil, we have, so far, temporarily achieved a small win where there has been a 120-day moratorium on fires. Again, this would be unheard of in, I would say, 10 years ago.

So small steps but in the right direction. But to conclude, I would say that we are constructive on the outlook for emerging markets for next year, not because we think that there will be a strong surprise of growth, but because we feel we’ve entered that crisis with relatively low-levered balance sheets, no animal spirit, and willingness of the government to implement more to the policies which is key to performance of emerging market fixed income. Thank you.

Great. Thanks very much, Polina. And similar to EM equities, the EM debt market appears to have some attractive pockets of opportunity going forward along with a favourable FX backdrop.

So let’s move on to some final thoughts as we wrap up today’s webinar. Laurence and Polina, just to quickly summarize some of the key messages that you reviewed today with our audience. Laurence, maybe I’ll ask you to start with a few remarks to wrap things up.

Yeah. Sure, Mike. Look, you’ve seen the chart. I mean emerging markets have underperformed for 10 years now and we really feel like we are at a turning point for asset class. And typically, it’s when you have something happen like a big recession, a reset. You press a reset button and then you can build up from that. And it’s really echoing what Polina was saying.

For emerging markets what we’re going to see, we’re going to see by comparison with developed market we’re going to have more growth, less debt, a dollar that’s going to certainly be weaker for some time. We’ve seen reforms in our countries. Polina mentioned South Africa. India has been implementing also very tough reforms over the past few years and they actually also showed with the numbers that they’ve been doing well during the pandemic. Brazil is doing well. China has definitely shown the world that they can do well.

So yeah. We are positive for asset class over the next few years. Obviously, the pandemic is still around here so we need to see really that under control, but yeah. We are quite positive.

Great. Thank you. Polina.

If I may add one last word, we know that today there are a lot of positive constructive views on emerging markets, and I think as a skeptical investor you would question well, how much this trait is positioned. And I think that’s where really the key difference lies. In our view, the optimism on emerging markets in terms of outlook is not met at all with the positioning where, in emerging market local currency debt there has been no real significant flows for the good part of the last five years. In emerging market hard currency debt we’ve only now started to see a reversal in flows, but flows are still negative on the year which only happens through the crisis period. So once every 10 years or so. And, therefore, we feel that you don’t have to—we’re not really taking a contrarian approach here when it comes to positioning. Or sorry, when it comes to the view because positioning is very light, and hence, despite the fact that we feel that it’s becoming more consensus that emerging markets could deliver performance, we feel that next year is likely to materialize as the flows follow the constructive outlook.

Great. And I just wanted to wrap up by thanking both of you for your remarks and then thanking everyone for joining us here today. We hope that you found the discussion to be informative and we do appreciate you taking time to participate in the webcast.

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Recorded on November 20, 2020


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