Candriam Sustainable Bond Emerging Markets - fund comment April 2024
The medium-term case for EMD is supported by relative valuations in the HY segment, and especially in frontier credits, disinflation, less restrictive central bank policies and a scenario of slowing but not collapsing growth in the US and in the rest of the world.
Market Overview
EMD HC (2.1%) gave back most of its prior month’s gains as 10Y US nominal and real yields rose sharply, by 48bps
and 40bps respectively, as recent US inflation and labour market data indicated that the US economy is not slowing
down as fast as hoped. EM spreads (-1bps) declined marginally with HY (-5bps) risk premiums continuing to outperform
IG ones (-1bps), contributing to positive Spread (+0.5%) and negative Treasury (-2.2%) returns.
The Fed held the Fed Funds rate in 4Q23 and so far in 2024 in acknowledgement of balanced risks to growth and
inflation but continue cautioning against premature rate cuts. Chairman Powell’s comments in November and December
indicated a progressively more dovish stance and FOMC on hold unless US labour markets exhibit resilience and
inflation pressures persist. Powell’s tone shifted to more hawkish in January and March 2024 signalling that the Fed will
proceed carefully with the launch of the interest rate easing cycle. In early April, he noted: “We do not expect that it will
be appropriate to lower our policy rate until we have greater confidence that inflation is moving sustainably down towards
2%”. Persistent inflation and labour market pressures have decisively pushed market expectations for cuts to the second
half of 2024 and reduced the number of expected cuts to two by Jan-25. ECB are similarly on hold since October 2024
but are likely to launch an easing cycle around mid-year, conditional on wage inflation outcomes.
The main focus for markets over the near term remains the US rates evolution and monetary policy, and whether activity,
inflation and labour market indicators confirm the Fed’s view of a “soft landing” of the US economy. We will also continue
monitoring the so far fragile Chinese recovery and the authorities’ reaction function to the over-leveraged private sector
next to EM and Eurozone growth and inflation dynamics for guidance on EM risk premium performance.
The rates (MOVE) and equity market volatility (VIX) declined marginally in April and remain close to their lows. Global
equity markets posted material gains SP500 (-4.2%), MSCI EM (+0.3%) while credit market performance was muted:
US HY (-0.6%), US IG (-1.9%). Oil (Brent crude up by 0.4%) and gas (European natural gas spot prices up by 4.2% to
€28.9/Mwh, TTF 1D) were supported by the persistent Red Sea route disruptions amidst tensions in the Middle East.
Industrial metals - Copper (+12.7%), Iron Ore (+16.6%) - posted positive performance on concerns over supply
constraints.
The trade-weighted US Dollar (-1.3%) weakened despite that 10Y US real yields rose by 40bps during the month (at
2.28% by end Apr-24). EMFX (-1.3%) marginally underperformed the Euro (-1.0%). CCC-rated credits outperformed
other categories (+0.7%) and the overall index. IG (-2.5%) under-performed HY (-0.9%) as the distressed credits
extended their recoveries. Venezuela (23.2%), Argentina (+11.2%), and Pakistan (+2.1%) posted the highest, and
Ukraine (-11.8%), Gabon (-4.4%), and Ghana (-4.2%), the lowest returns in April.
For 2024, JP Morgan forecast $152.8 of gross and +$20.5bn of net sovereign supply and $244bn of gross and -$190bn
of net corporate supply. EMD LC issuance, ex China, is expected at $608bn or 28% up versus the $477bn realized in
2023. Global EM corporate default rate forecast of 4% for 2024 incorporate an assumption on only marginal deterioration
of EM corporate fundamentals. In line with seasonal trends, gross issuance was heavy during the first four months of
the year with $104.1bn, or 68% of the expected gross issuance placed by EM sovereign issuers. Issuance was
concentrated in IG issuers although some HY issuers returned to markets after several years of hiatus (Benin, Ivory
Coast, Kenya). The YTD net financing of $56.3bn was absorbed by investors' cash balances while HC asset class
outflows persisted (-$11.8bn split between -$6.2bn HC and -$5.6bn LC). Notably, the EMD asset class continues to
receive outflows even after two consecutive years of combined $128bn of outflows ($94.1bn in 2022 and $33.7bn in
2023).
Portfolio Highlights & Strategy Review
The Fund underperformed the reference index by 38 basis points in April in net terms, delivering -2.46% vs. -2.08% for
the benchmark. The largest driver of underperformance was the underweights in ratings-excluded countries, esp. the
underweight in Argentina (approx. -17 bps contribution) and Ecuador (-6 bps). The main positive contributors were
underweights in treasury-sensitive IG Gulf country issuers, which are excluded by Candriam’s sustainable model.
The main changes in positioning over the month were taking profit in Bulgaria (1.0%; fully exited), trimming our
position in Mexico (-1.2%) and Turkey (-0.5%). We added to our positions in Romania (+0.8%), Colombia (+0.5%) and
Brazil (+0.4%).
Fund Outlook
Relative EMD HC valuations in EM HY offer some residual value versus asset class fundamentals and DM Credit while
EM IG valuations appear fair. Absolute valuations do not screen attractive as EMD HC offers a spread over US
Treasuries of 373bps, or 39bps inside its 5-year average of 412bps. The HY versus IG spread over US Treasuries
differential is 483bps, or 70bps inside its 5-year average of 553bps, with the value concentrated in the distressed CCC
and D-rated universe of 15 countries with 5.9% index weight. At the same time, the EMD HC yield of 8.5% offers 1.9%
over its 5-year average of 6.6%, with similar elevated carry levels traditionally attracting some asset class interest.
The medium-term case for EMD is supported by relative valuations in the HY segment, and especially in frontier credits,
disinflation, less restrictive central bank policies and a scenario of slowing but not collapsing growth in the US and in the
rest of the world. The Russian invasion of Ukraine and the parallel financial and political isolation of Russia fuelled
energy and food price inflation globally which required central bank tightening in 2022 and most of 2023. We expect that
in 2024, the adverse dynamics for fixed income markets are reversed. We expect that inflation continues to decline
towards targets and that growth slows but that the US avoids a recession. The Fed should react to the tighter financial
conditions it has engineered via its 525bps cumulative rate hikes yet the launch of an easing cycle will remain data
dependent. ECB may have over-tightened and the Eurozone may enter a short-lived technical recession in 2024 yet
with no significant consequences for the rest of the world. China will likely deliver enough stimulus to ensure growth
remains in the 4.5-5% range in 2024 while growth in EM ex China will slow marginally but remain just under 4%. The
key global macro headwinds to EMD remain deeper than expected DM central bank hiking cycles in response to
persistent inflation and subsequent harder landings of the American and European economies.
High funding costs and limited access to external financing may tempt some vulnerable EM countries to default but these
risks are mostly priced in by EMD HC sovereign valuations as EM spreads already incorporate an assumption of a %
default rate at a conservative recovery rate of 30%. Uncertainty around the de-rating of the EM universe and the
resolution of specific liquidity and solvency issues in some EMs remain, but these are going to be addressed on a caseby-case basis. We note that IMF and bilateral lenders have worked actively with distressed EM governments to mitigate
default risks in Egypt, Kenya, and Pakistan.
Our moderately constructive commodities outlook is based on the assumption of slowing but not collapsing global
growth. We expect that in the medium term, US Dollar weakness is anchored by the sizeable twin deficits the economy
has amassed and by the near doubling of the Fed's balance sheet in 2020. In late 2023 and early 2024, as the US
economy slows down, we may observe the beginning of this medium-term soft US Dollar trend that may finally reverse
the longer-term weak EM currency trend. Yet US Dollar has outperformed EM FX and G10 FX during recessionary
periods which raises the uncertainty around EM currency performance in 2024.
On a one-year horizon, we expect risk premiums to rise but that carry and duration effect support positive total returns.
On an assumption of 10Y US Treasury yields between 3.5-4% and EM spreads between 400-450bps, EMD HC returns
may be around 5-12%.
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