China, inflation, ESG dominate EM bond investor thinking

What are the biggest sources of potential volatility for EM in 2022?

Timothy Ash, senior emerging markets sovereign strategist, Bluebay Asset Management
First of all, core market rates and inflation. Will inflation be transitory or permanent, and are developed market central banks getting behind the curve? In China, the question is what sectors or names will be next to face increased regulatory oversight after Xi Jinping’s focus on real estate and education. Staying with China, I would not exclude the risks from rising tensions around Taiwan, and possibility of an accident that hits US-China relations.

I would add the risk of war in Europe, of Russia invading Ukraine. I am also worried about the Balkans, with risks of a push for independence by the Republic of Srpska unravelling the Dayton Peace Accord and resulting in instability in Bosnia and Herzegovina and the wider Balkans.

Omotunde Lawal, head of emerging markets corporate debt, Barings
China’s growth momentum is a key one to watch. We are already seeing downward revisions to China growth forecasts for Q4 2021, and for 2022. Geopolitical risks will also be important especially, between the US, China and Taiwan.

Other things we are watching are the risks of new Covid-19 variants leading to mobility restrictions again, and elections in EM countries like Brazil.

Richard Segal, research analyst, Ambrosia Capital
The main risks are that the Fed and ECB are behind the curve in tackling inflation, the appearance of additional Covid-19 infection spikes and US-China tensions or contagion from problems in the Chinese property sector.

Other broader risks include domestic political events and high and rising public debt in many countries.

Jennifer Gorgoll, senior portfolio manager, Neuberger Berman
The biggest source of potential volatility is the Fed. As of today [interviewed before Jerome Powell was nominated for a second term], we are not even sure who the Fed chairman is going to be, much less how aggressive (or not) the Fed will be.

Rates and spreads could be impacted by a more hawkish stance as tapering continues and rate hikes, which will likely start in 2022, take hold. Other main concerns could be a China slowdown — hard versus soft landing — which could also lead to commodity volatility.

Krishan Selva, client portfolio manager, emerging market equities, Columbia Threadneedle Investments
From a top-down perspective, factors such as Covid-19 variants, vaccine distribution, inflation concerns, commodity prices, regulation and geopolitical risks are the biggest sources of potential volatility. The outlook for inflation remains a key issue for both emerging and developed markets, as central banks may begin to moderate monetary policy accommodation.

In terms of US-China relations, we can expect the current stance from the Biden administration to remain unchanged given the bipartisan support in Washington for its policy towards Beijing, with the current administration also likely to have the support of allied countries. The team is continuing to monitor geopolitical risk.

Which countries or regions are most at risk or most robust?

Ash: If we are in a higher rate environment, those at risk would be the higher rolling credits with higher debt burdens and larger external financing requirements. Sri Lanka, Turkey, Egypt and Tunisia will be in focus. It seems like oil/commodity names look more resilient. In the Gulf Cooperation Council it’s notable that balance sheets are being helped by higher oil prices but we’re also seeing major reform efforts in Saudi Arabia, UAE and Oman.

Lawal: China is one that seems to be undergoing a structural transformation/reform process at the moment, so there are execution risks at play there. Brazil is also a key market to watch in 2022 as we head into presidential elections in October. Most robust regions would be some of the Southeast Asian nations like Vietnam and some of the commodity countries.

Segal: The frontier markets in general are most at risk, and most robust are those which are battle-hardened or that benefit from high oil prices, such as Mexico and the Asian economies.

Gorgoll: China continues to be at risk given the volatility in the property sector, which could spill over to other sectors. We expect China to slow dramatically next year, potentially into the low single digit growth level.

Apart from China, we see political risks increasing in Latin America as a number of important countries will go through elections. Brazil’s elections, which will take place in October 2022, will be the highlight as the Left candidate will have a strong possibility of winning.

Selva: As bottom-up stock pickers, the country exposures are primarily driven by stock selection. We do evaluate top-down considerations, but their impacts are viewed through the lens of the companies we invest in. Therefore, we do not make country or regional bets, and allocation decisions reflect stock selection.

As of the end of October, our fund’s key overweights were Russia, Brazil, Indonesia, Singapore and Hungary. While the largest underweights were Saudi Arabia, Taiwan, South Africa, Mexico and India.

How much importance do you place on ESG when buying bonds?

Ash: ESG is now huge for our industry. We’ll see whether Article 8 under Sustainable Finance Disclosure Regulation will limit market financing for higher risk ESG stories, and whether it will encourage ESG related reform in these same credits.

Lawal: The team focuses and places a high importance on ESG in the investment process. We see it as an opportunity to partner with issuers in EM to accelerate the transition process to the green economy. We score each issuer on a scale of one to five on each of the environmental, social and governance policies. However, we do not operate an exclusion policy but utilise engagement as a tool with the issuers.

Segal: It has, for better or worse, become all important. But there is still limited available data for the analysis of ESG, and limited human capital to analyze what is available. It is also difficult to quantify how relevant the available ESG data should be to investment decisions.

Gorgoll: Extremely important. ESG is an integral part of our process, and we review ESG factors on every company that we invest in.

Selva: We place a lot of importance on ESG. Understanding how well a company manages its material environmental, social and governance risks is key to assessing the quality of an investment. In our view there are three key reasons to focus on ESG in emerging markets: the first is simply for alpha, we believe those companies which focus on their specific ESG exposures will generate sustainable returns; the second is the impact of policymakers, which has shifted over recent years creating a supportive macro backdrop; and finally we have the power of engagement, a tool that active managers can utilise to help develop and transform business practices.

Will EM weather Fed tapering and rate rises more smoothly than in 2013?

Ash: It’s hard to tell. There is a very challenging environment for emerging markets with rising inflation, rising rates and likely more subdued growth. EM has also seen indebtedness rise through the Covid-19 crisis. Structural reform and fiscal consolidation would normally be the prescription, but we are seeing challenging political settings in many countries, and that environment is not greatly encouraging for reform.

Lawal: EM economies and corporates are in a much healthier position than in 2013. Current account balances are much healthier and corporate leverage is lower, so the starting point for balance sheets compared to 2013 is much better. In addition, EM credits have completed huge amounts of debt refinancing in the last two years when rates were low, so they have locked in relatively cheaper funding.

Segal: Tapering is unlikely to be an issue this time around because it was well telegraphed and investors have been better prepared. But in the event of higher for longer ‘transient’ inflation, this is not necessarily the case.

Gorgoll: Yes, I think so. Tapering in 2013 was not as well broadcast as it is now. The Fed has been more careful about being transparent regarding the timing of tapering and the potential for rate hikes to start in 2022. I believe this increased transparency goes a long way to providing the markets with a game plan to better digest tapering and hikes as they happen.

Having said that, there will still likely be some surprises as the Fed may need to change its timing in reaction to changing data, but swings should be less volatile than what we saw in 2013.

Selva: Since 2013 many emerging economies went through painful rebalancing and have progressed with domestic reforms. The notion of the “fragile five” is no more, it seems to be just Turkey who is vulnerable. Even if we exclude China (which has a large current account surplus), in aggregate emerging economies are in a current account surplus.

Emerging markets are breaking away from their dependence on the developed world, given heightened domestic demand. Therefore, we don’t have the same weakness in different pain points.

What key themes will emerge for EM investors in 2022?

Ash: In addition to the ones touched on — inflation, rates and China — Turkey might be an interesting story next year. There is the possibility that President Erdogan opts for early elections and perhaps even loses. Turkey is currently a ‘steer clear’ for many investors, but a change in administration and new faces at the central bank could make the country a turnaround trade for 2022/23.

Lawal: Inflation and pressure on margins will be something to watch for corporate issuers in 2022. We will also be keeping an eye on climate change effects and impact to supply chains and the agricultural sector once again. Sustainable financing will also be another key theme for 2022.

Segal: The main topics will be inflation and central bank reactions, global health and travel normalisation, the US congressional elections and geopolitics.

Gorgoll: The key themes are likely to be increasing inflation, hawkish central banks (developed and emerging markets), supply chain constraints, rate volatility, political uncertainty/elections in emerging markets, China slowdown, and a potential energy crisis if supply/demand issues become pervasive.

Selva: We believe the key long-term trend for the asset class is the transition from predominantly export-led growth to reliance on buoyant domestic demand. Investors are now buying structural growth companies, the likes of TSMC, Tencent, Alibaba, Samsung, JD and HDFC. This is because the universe now favours structural growth and is no longer dominated by commodity-sensitive, cyclical companies or companies with a large state presence.

Structural wealth creation, the rising middle class, and the associated changes to consumption and services is the dominant theme in our fund. GC