Emerging Markets Debt (EMD) holds a significant position in the global financial landscape and has grown substantially in recent decades. As of 2020, EMD stood at approximately $24 trillion, accounting for 25% of the global bond universe—a substantial increase from its 2% share in 2000, according to Vanguard. Despite this growth, the percentage of EMD relative to the gross domestic product (GDP) share of emerging markets in purchasing power parity (PPP) terms, at 63%, indicates further potential for expansion. EMD encompasses Sovereign EMD, involving bonds issued by national governments, and Corporate EMD, involving bonds issued by corporations in emerging economies. EMD also is categorized into hard-currency bonds, denominated in currencies such as U.S. dollars (USD) or euros, and local currency bonds.

The Importance of EMD in a Diversified Portfolio

The rapid growth of the GDP of emerging markets compared to developed markets—alongside the increasing size of the EMD market—positions EMD as an attractive investment opportunity. Additionally, EMD exhibits relatively low correlations with other fixed-income assets, making it a valuable portfolio diversifier. Unlike emerging market equity (EME), the country breakdown of EMD features lower country-concentration risks, offering more balanced exposure across various economies.

EMD Performance in Recent Years

The onset of the pandemic in 2020 triggered a wave of panic among investors, leading to a typical “sell first and ask questions later” approach toward EMD. This resulted in a sharp increase in yields and spreads. The situation somewhat stabilized as the Federal Reserve (Fed) and other central banks implemented unprecedented easing measures. However, in the second half of 2021 and particularly in 2022, central banks adopted aggressive interest-rate hikes in response to heightened inflationary pressures, significantly impacting fixed-income asset classes globally. Additionally, Russia’s invasion of Ukraine in the early months of 2022 caused a significant sell-off in Russian and Ukrainian bonds. This created a spillover effect on bonds from other emerging market (EM) countries. EMD investors navigated challenges such as tight global liquidity, elevated interest rates worldwide, a strong USD, and heightened geopolitical risks.

The turning point for EMD came in 2023 marked by a strong performance driven by improvements in the macroeconomic environment, as the Fed paused rate hikes and some EM countries started cutting rates. EMD had outperformed the U.S. Aggregate Index (U.S. Agg) significantly in 2023, though it lagged U.S. High Yield (U.S. HY). Year-to-date, EMD continues to outperform U.S. Agg, and we anticipate another strong year for it. Our research indicates EMD could be an attractive asset class for overweighting in portfolios, given its reasonable valuation,solid fundamentals, and improving investor sentiment.

Performance comparison

Source: Bloomberg

Valuation

Coupon income from EMD, also known as “carry,” remains highly attractive. Carry contributed 163 basis points to the total return of EMD (USD-denominated) in the first quarter of 2024. Considering the average carry of 527 basis points during the last 10 years, we anticipate a more significant contribution from carry to the overall EMD return by year-end.

Coupon income from EMD has been a big contributor to total return.

Source: Bloomberg

EMD spread over U.S. Treasury yields has tightened since the end of 2022, but it is still much higher than pre-pandemic levels. More importantly, EMD spread is much higher than the U.S. investment grade (U.S. IG) and U.S. HY spreads, which are approaching historic lows. For investors seeking yields, EMD currently presents a more attractive option than U.S. IG and U.S. HY bonds. Historically, EMD has delivered better returns compared to US IG; While US HY has offered higher returns than EMD, but US HY has much higher volatility.

Fundamentals

Economic Growth

A “soft landing” scenario in the U.S. presents a favorable environment for EMD. Investors tend to show a better appetite for riskier fixed-income asset classes such as EMD during such periods. Conversely, a “hard landing” scenario would pose challenges for EMD, as investors typically seek safety, often shifting toward more predictable assets such as U.S. Treasurys. Similarly, an excessively rapid economic-growth environment also can be problematic for EMD, as central banks may maintain high interest rates, which is generally unfavorable for fixed-income assets. A “soft landing” is our base case for the U.S. in 2024, which would provide a tailwind for EMD investors.

Furthermore, a higher overall growth rate in emerging markets (EM) compared to developed markets (DM) is advantageous for EMD. We expect a significantly larger growth difference between EM and DM economies in 2024 compared to recent years. Despite recent strong economic data, we anticipate a moderate slowdown in the growth of the U.S. economy in 2024. Additionally, we expect other developed economies to experience a meaningful deceleration, influenced by the delayed effects of higher interest rates. However, EM countries are poised to perform better, notwithstanding challenges in China. Recent economic data from EM countries have exceeded expectations.

Current account balances in EM countries are on an upward trajectory, with notable improvements expected. A positive current account balance means the country is a net lender to the rest of the world, and a current account surplus increases a country’s net foreign assets. Typically, a positive current account is a result of more exports than imports. Most EM countries are projected to witness enhanced current account balances in 2024, with significant improvements anticipated in Chile, Colombia, Hungary, and the Czech Republic.

Current account balances in EM countries are expected to improve in 2024.

Source: Bloomberg

Inflation and Interest Rates

The disinflation trend in major countries around the world is expected to continue, albeit with potential bumps along the way. We anticipate that the Fed will commence rate cuts later this year. The Fed is navigating a delicate balance, concerned about the resurgence of inflation while also wary of overly restrictive monetary policies that could harm the job market and potentially lead to a recession. Market expectations for federal funds rates have adjusted significantly since the beginning of the year, and the 10-year U.S. Treasury yields have risen significantly from the end-of-2023 lows to around 4.5%. Along the way, EMD has done well despite the U.S. rate adjustments.

While a fluctuating disinflation trend in the U.S. may introduce some volatility to EMD, the overall environment remains favorable as long as disinflation trends remain intact— especially given the significant repricing of rates since the end of last year. Good year-to-date performance of EMD has demonstrated that this asset class can still deliver good results despite volatility in the U.S. rates market.

Some EM countries’ own inflation releases have surprised to the upside lately. But, looking under the hood, the main culprit is food price, while core disinflation remains intact. EM central banks boosted their credibility when they raised rates facing inflation in 2021—ahead of major DM central banks. Some EM central banks already cut rates last year, and more began cutting this year. This would create a tailwind for EMD, as interest rates have an inverse relationship with bond prices. Forward markets are pricing in lower three-month yields in 13 of 16 major EM countries during the next year. Having said that, with recent hotter inflation reports in the U.S. and fewer expected rate cuts by the Fed, some easing from EM central banks could be delayed.

Many EM countries are expected to cut rates in 2024.

Source: Bloomberg

Sentiment

Following the pandemic, foreign flows into EMD significantly declined. While flows marginally recovered later in 2020, foreign investors were once again retreating from EMD by early 2021. In 2022, the outflows from EMD were about $90 billion; in 2023, the outflows were much smaller at $34 billion. Year-to-date, outflows from EMD tapered around the start of April. As these numbers show, investors may gradually be feeling more comfortable with EMD. Despite the strong performance of EMD in 2023, we still consider it a favorable time to buy EMD, given the potential turnaround in investor sentiment.

Risks

There certainly are risks, as is the case with any investment. We see two major risks for EMD in 2024: First, if inflation in the U.S. proves to be stickier and the Fed’s cuts are less than markets expect, EM countries would be impacted negatively; second, there are significant geopolitical risks in 2024, which could potentially lead to increased volatility.

Conclusion

Within Pacific Life Fund Advisors, we use a quantitative and qualitative approach to investing by analyzing economic and market data continuously and adjusting our portfolio accordingly. Based on our analysis, we expect EMD to perform well this year with favorable valuation, fundamentals, and investor sentiment. We anticipate EMD yields to fall as more central banks cut interest rates. Its better valuation versus other fixed-income asset classes makes us more comfortable overweighting this asset class. After quite a few years of very negative investor sentiment, it seems investors are warming up to EMD again. Even with the associated risks, we believe EMD looks attractive against many other fixed-income asset classes at this moment, and it may be a good time to buy.

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This material is educational and intended for an audience with financial services knowledge.

Pacific Life Fund Advisors LLC (PLFA), a wholly owned subsidiary of Pacific Life Insurance Company, is the investment adviser to the Pacific Select Fund (PSF) which is available through certain Pacific Life variable annuities. PLFA directly manages certain PSF funds-of-funds.

This commentary represents the views of the portfolio managers as of 4/17/24 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector, or index, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Sector names in this commentary are provided by PLFA and could be different if provided by a third party.

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