Emerging market economies are among the brightest spots in what is an improving global growth outlook. Fundamentals are strengthening across the developing world, with current accounts improving significantly in recent years. In addition, inflation has moderated and emerging central banks are once again building up reserves. 
While many investors are concerned about the impact the Federal Reserve’s interest rate hiking cycle may have on emerging market debt, we believe these fears are unfounded and largely based on the volatility surrounding 2013’s taper tantrum. In fact, during the last sustained Fed hiking cycle between 2004 and 2006, both emerging market hard and local currency debt markets were strong performers.
In addition, emerging market debt spreads are still attractive relative to developed market peers and the level of credit risk in the market. Spreads are also well above the all-time tights witnessed in 2007.
In this environment, we remain constructive on the emerging market debt asset class as we move into 2018. Areas that we believe present opportunities include the Americas – namely Argentina, Brazil and Mexico – as well as Ukraine and select frontier countries.
We also view the market as too pessimistic on recently-defaulted Venezuelan debt as we believe it has the ability to achieve a higher recovery rate over the medium term than is currently priced into the market. Short term, we do not rule out downside risk given the unstable situation, but a longer-term view is warranted. See our view of fixed income markets in the regions below.
Macri momentum to continue Argentinian recovery
We believe the Argentine government can capitalise on the mid-term election victory by improving fiscal and inflation dynamics. It is important for Argentina to continue its positive momentum and deliver on fiscal reforms though 2018 and 2019.
The improved policy mix should boost investment and capital inflows into the country. Argentina will likely approach high single-B to low-BB valuations if the strategy proves successful. We believe its provincial and euro-denominated bonds offer the best value, but are waiting for more pronounced signals from the central bank to buy into FX more strategically.
Brazilian debt still offers upside despite political noise
The economic recovery should be more meaningful in 2018, which is important in an election year. Pension and other reforms are needed to stabilise debt dynamics. The election outcome will determine how Brazil performs over the medium term; at stake is the degree of commitment to market friendly and debt stabilising reforms, along with policies to improve investment.
Current spreads on Brazilian sovereign debt look fair relative to other emerging market debt BB-rated issuers, with the low level of external indebtedness and high FX reserves limiting the downside. Against this backdrop, select quasi-sovereigns are attractive.
Local bonds are also attractive in nominal and real terms compared to other local emerging markets. The Brazilian real currency could also benefit from healthy foreign direct investment. As the political cycle heats up next year, bouts of volatility may provide attractive points to add risk.
Risks have not derailed Mexican debt and FX opportunity
While Mexico faces headwinds from a combination of domestic and external risks, fixed income assets in the country have bounced back this year. External quasi-sovereign debt looks attractive and is trading at wide levels compared to the sovereign. Select Mexican corporate bonds also offer value and good diversification.
We believe local bonds in the country have not yet priced in potential rate cuts from Banxico. The yield curve is attractive in the medium-to-long term, given the roll down and steepness. In addition, we foresee long-term value in FX.
Market underestimating potential Venezuela recovery rate
We expect little contagion in the LatAm region following the Venezuelan default. The Venezuela problem is quite unique, as the country is extremely levered to oil and its authoritarian regime has failed to enact policy reform. In our view, a change of regime and a change in policies is needed before restructuring can take place.
If we assume a change of leadership – alongside other bilateral assistance from the likes of the International Monetary Fund (IMF) – there is a reason to believe Venezuela, and importantly oil production, can stabilise, as many international oil companies would be interested in entering the country.
In a scenario where there is a stable government, a recovery value of close to 50 cents on the dollar for the debt of Petróleos de Venezuela (PDVSA), the troubled state-owned oil and natural gas company, is not out of the realm of possibility – far improved on today’s levels.
Cathy Hepworth is manager of the Nordea 1 – Emerging Market Bond and Emerging Market Bond Opportunities funds. All views are her own and should not be taken as investment advice.