Emerging market debt (EMB) has struggled over 2022 so far, as the asset class bore the brunt of Russia’s war in Ukraine and the post-Covid economic hangover. 
However, Federated Hermes said EMD valuations are now at a level of attractiveness that fixed income markets seldom see, especially when a lack of idiosyncratic risks and low rate of default are taken into account.
Jason DeVito and Mohammed Elmi, lead portfolio managers at Federated Hermes, said: “EMD investors, therefore, find themselves at a fork in the road.
“Do they follow consensus and take flight, or grasp an unprecedented opportunity to build a long-term position in an asset class that has come of age and is still exposed to the structural drivers of global growth?”
Below they offer seven reasons why investors should consider emerging market debt from here.
1. Valuations
DeVito and Elmi argued that EMD could be considered the “sale of the century” as valuations are currently in line with those of equities.
“Given that fixed income traditionally outperforms equities on the downside – by virtue of being a more stable, defensive asset class – the equal valuation footing upon which they currently stand suggests that EMD has been vastly oversold,” they explained.
“As a result, investors with the bandwidth to accommodate more risk and believe in the long-term emerging market growth story, should consider current valuations as a unique buying opportunity.”
2. Global challenges priced in
The entire market has been rattled by Russia’s invasion of Ukraine, but EMD has been among the assets that were hardest hit. However, the Federated Hermes managers think markets have now largely priced-in the global economic impact of the invasion.
The other main drags on EMD performance this year are the outlook for growth and inflation, but the managers are also sanguine on these issues, especially as the Federal Reserve has offered more insight into its plans to tighten policy.
“With its tightening stance no longer an unknown, fixed income investors can begin to reassess their positions in light of the knowledge that inflation will likely be capped by Fed action in the medium term,” they said.
“Now that we know the general pace at which the Fed is likely to tighten policy, we are confident that a major global recession, similar to the global financial crisis, is unlikely. Overall, this supports the case for buying into EMD at current levels in anticipation of a more accommodative market environment in H2.”
3. Idiosyncratic strength
DeVito and Elmi’s third argument in favour of EMD revolves are the fact that although the global economy is facing several high-profile challenges, there are only a handful of idiosyncratic risks coming out of emerging markets themselves.
“Since the outbreak of Covid, and despite the great economic stress that has ensued, we have seen only one EM default on the hard currency side (Sri Lanka),” they explained.
“In line with wider evidence, this suggests that countries across the regions are increasingly well-managed and fully capable of servicing their debt. Distressed pricing in the asset class means there are potentially high returns on the table and, even if country-specific issues did arise, valuations are more than accommodating.”
4. Commodity prices pick-n-mix
Although some investors still regard emerging markets as a homogenous group that display more or less the same risks and rewards, DeVito and Elmi pointe that they are a diverse set of countries with distinct characteristics.
“In times of distress, an individualised approach to the countries that comprise the asset class is more important than ever,” they added.
The managers highlighted energy producing countries as a sub-group of emerging markets that look well-placed to continue benefitting from higher energy prices in the second half of the year.
Likewise, some of the Middle Eastern and sub-Saharan African countries that were previously under strain, such as Angola, Bahrain, Oman and Gabon, have used higher commodity prices to deleverage and reduce external vulnerabilities.
5. Tailwinds in H2
The Federated Hermes managers also argued that the main emerging market are likely to move past a number of political hurdles over the second half of 2022, which could reduce some of uncertainty around EMD.
These hurdles include the Brazilian elections and the 20th National Congress of the Chinese Communist Party.
Moving past these events could stabilise the political outlook and “many investors are likely to return to the asset class in the fourth quarter as a result”, DeVito and Elmi said.
6. The DM-EM divide
The managers believe some emerging market corporates are “very much best of breed”, only their credit ratings are lower than equivalents in the developed markets because country ceilings apply downward pressure on their ratings.
“We believe the strongest opportunities in EMD currently lie in the BB/BBB space, both on the sovereign and corporate side,” they added. “Issuers in this band of the asset class tend to display ample free cashflow, and countries are largely well-run and generate fiscal surpluses.”
7. Charting its own course in ESG
DeVito and Elmi finished by pointing out that EMD is a tough asset class for ESG integration as sovereigns and corporates are at a much earlier stage of their ESG journey.
However, they added that this could create “a compelling opportunity for investors”.
“As current global challenges ease, we expect resurgent interest in ESG-focused investments across the region and investors can benefit from identifying the most interesting names early,” they concluded.