Investors returning to emerging markets debt after battering in 2022

Emerging markets are once again back on the agenda for institutional investors and money management executives, as China's reopening and an expanded growth differential vs. developed countries drive interest and inflows.

Debt was highlighted by managers as a huge opportunity for 2023, as the technical and fundamental pictures that are particular to emerging markets align with a softening dollar and ESG credentials. Sources expect double-digit returns for the asset class — with the caveat that a recession would spoil that party.

Emerging markets debt "has been beaten up to smithereens," said Barry Kenneth, London-based CIO at the Pension Protection Fund.

"Some of these countries out there are commodity exporters and they're trading at below the recovery rate. It's a volatile ride in EM and it hasn't been a great asset the last couple of years, but if you just look at the fundamentals it should be an asset class that does relatively well as soon as the dollar becomes less expensive," he said. The PPF has £39 billion ($47.6 billion) in assets and is the lifeboat fund for plans of insolvent U.K. companies. The PPF had a 4.2% allocation to emerging markets debt as of March 31.

A number of U.S. pension funds responding to Pensions & Investments' annual survey of the 1,000 largest retirement plans showed increased allocations to emerging markets debt. California Public Employees' Retirement System, Sacramento, which had defined benefit assets of $430.4 billion as of Sept. 30, almost tripled its exposure to emerging markets debt over the year, to $9.5 billion.

A spokeswoman said the change reflects the fund's new asset allocation — which took effect July 1 — and "our efforts to meet our required return."

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CalPERS' new asset allocation includes an increased exposure to fixed income to 30%, which includes emerging market debt, vs. 28% previously, and the investment return target was unchanged at 6.8%.

Connecticut Retirement Plans & Trust Funds, Hartford, with $40.6 billion in assets, reported a $1.7 billion exposure to emerging markets debt. A spokeswoman for the Connecticut Office of the Treasurer said the CRPTF has "targets regarding the level of EMD exposure … and that amount at year-end was above the new target that was approved in September 2022." The allocation to non-core fixed income, which includes emerging markets, is 2% under the new strategy. Further information was not available.

"We do have a strategic plan in place to reduce exposure over time — but we always strive to balance reducing overall exposure with taking advantage of the best opportunities for growth," the spokeswoman added.

Other pension funds that recorded an increase in allocations to emerging markets debt over the year included the State of Wisconsin Investment Board, Madison, with a 16.2% increase to $2.7 billion in its $117.2 billion defined benefit portfolio, and the $66 billion Pennsylvania Public School Employees' Retirement System, Harrisburg, which almost doubled its allocation to $820 million. Spokesmen for the plans did not respond to requests for comment.

Investors with exposure to emerging markets debt had a rough ride over recent years. The J.P. Morgan EBMI Global Diversified Composite index lost 17.8% in 2022, following a -1.8% return in 2021. Year-to-date through Feb. 6, the index has already made a sharp turnaround and gained 3.3%.

Investor flows reflected emerging markets debt's tough time. In 2022, investors pulled $110.5 billion from the strategies, according to data from EPFR Inc.

However, emerging markets bond funds attracted $2.5 billion in net inflows in the third week of January alone, according to EPFR. Total net inflows to emerging markets debt strategies were $7.9 billion year-to-date as of Feb. 1.

The battering that emerging markets debt strategies took in 2022 is just one aspect of the now-positive sentiment toward the asset class. "Outflows and risk-off trades appeared exhausted, and managers raised cash throughout 2022," Kristin J. Ceva, managing director at Payden & Rygel in Los Angeles, said in an email.

"In recent weeks, the flow picture is more favorable, helped by high yields and good prospects for medium-term return."

And there are other reasons for positive sentiment on emerging markets in general.

"We expect emerging markets to do well in 2023," said Kunjal Gala, head of global emerging markets at Federated Hermes Inc. in London. "In addition to trough valuation and light investor positioning, we expect the EM-DM growth differential to expand, driven by favorable demographics, manufacturing capability, availability of critical resources and focus on supply-side reform/infrastructure. Growth will be challenging as central banks unwind loose monetary policies and governments cannot pursue large-scale fiscal stimulus," Mr. Gala added. Federated Hermes had $624.4 billion in assets under management as of Sept. 30.

In early January, the World Bank Group forecast 3.4% GDP growth for developing and emerging economies — flat compared to its estimated growth for 2022. Advanced economies, however, are set to grow 0.5% in 2023, significantly lower than 2022's estimated GDP growth of 2.5%.

But "there is a caveat to the Chinese reopening," said Damien Buchet, CIO at Finisterre Capital in London.

And that's whether it is "an extra cause for inflation. It could (be) to a degree" due to pent-up demand from citizens and increased consumption across consumer staples, oil and other commodities — although investors are placated by positive experiences with regards to reopenings across the U.S. and Europe, he said.

However, Chinese growth is likely to rebound strongly, which will support emerging markets growth and commodities even as the U.S. and Europe slow, Mr. Buchet said. He added that China's GDP growth is set to reach 5.5% in 2023, up from 3% in 2022.

Finisterre had $3.1 billion in assets under management as of Dec. 31. The firm is a boutique manager within Principal Asset Management, part of Principal Financial Group.

But sources also pointed out that inflation is not such a big concern for investors looking at emerging markets, since these countries' central bankers have dealt with it before.

"It's interesting that emerging markets central banks were more proactive and aggressive at hiking rates than the Fed was," said Carlos de Sousa, emerging markets strategist and portfolio manager at Vontobel Asset Management in Zurich. That may be "because a lot of central bankers had already in their careers seen high inflation … they didn't have to read it in textbooks." The firm had about $124 billion in assets under management as of June 30.

Werner Gey van Pittius, co-head of emerging market sovereign and FX at Ninety One in London, agreed. "EM central banks only know one playbook — when inflation goes up, they hike rates and tighten financial conditions. They have to be orthodox, otherwise the market will punish them. They also know the perils of unhinged inflation, in some parts due to bitter experience in the '80s."

With the U.S. and European Union still working to cool inflation, "this leaves EM bonds in a really attractive position," he said. Ninety One had £132.3 billion in assets under management as of Sept. 30.

Inflation in Brazil, for example, was 5.8% in December, vs. 6.5% in the U.S. and 9.2% in the U.K. Inflation in Brazil peaked at 12.1% in April for 2022.

Sahil Mahtani, London-based strategist at Ninety One, thinks the divergence between emerging and developed markets' policy paths in response to the COVID-19 pandemic — with less monetary and fiscal stimulus in emerging countries — is key in assessing opportunities. Tightening policy earlier in the pandemic, and less monetary and fiscal stimulus than in developed markets, "should mean less entrenched inflation, in the context of high yields from economies with improving macro fundamentals," Mr. Mahtani said.

But there are very real risks for emerging markets debt performance in 2023, which although not base cases, cannot be brushed aside.

One is "a good, old-fashioned recession," said Arun Sai, senior multiasset strategist at Pictet Asset Management.

While emerging markets are getting a growth boost from China's reopening, even as Europe and the U.S. remain "quite stagnant … if we see a full-on recession in the U.S., then I would struggle to argue that EM in that environment continues to perform," he said.

Lazard's Ms. Simon agreed that recession is "chief among" the risks for emerging markets debt. "The global tightening cycle has been one of the largest and most synchronized in recent history and its effects have yet to be fully felt," she said.

Insight's Mr. Cooke agreed, adding that a "harder or earlier U.S. recession than people expect … could disrupt markets."