EM Debt: The Improving Risk/Reward Dynamics

Greg Campion: Emerging markets debt has arguably been out of favor over the last year- plus as rising rates and increased geopolitical risks have made staying closer to home a more attractive prospect for many developed market fixed- income investors, but with a potential inflection point in interest rates on the horizon and a number of political risks, especially EM elections in the rearview mirror, could it be EM debt's time to shine once again?

Dr. Ricardo Adrogue: Today in emerging market debt, we are finding great opportunities. The interest rate cycle is about to start with cuts, PAM flows are starting to come back, and political risk in emerging markets are behind after all the elections that have taken place.

Greg Campion: That was Dr. Ricardo Adrogue, head of Global Sovereign Debt and Currencies at Barings. And this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion. Coming up on the show, is there value today in emerging markets debt? Before we get into the conversation, if you're not already following us and you're interested in hearing our latest thoughts on asset classes like high yield, private credit, real estate, and more, just search Streaming Income on Apple Podcasts, Spotify, YouTube, or wherever you get your podcasts. With that, here's my conversation with Ricardo Adrogue. Ricardo, welcome back to Streaming Income.

Dr. Ricardo Adrogue: Thank you. Great to be here.

Greg Campion: Excited to have you here. Thanks for making the trip to Charlotte for this. Always exciting to have you in town. So we have a lot to talk about today. Want to talk about emerging markets broadly and a lot of the risks associated with emerging markets and I'd be interested to hear where we are today with a lot of those risks. But I want to set this up. I have this one overarching question that I wanted to add here as context. So basically, I want to think about whether or not it makes sense for developed market investors to take on the additional perceived risk that emerging markets may or may not pose, so things like currency risk, things like political risk, rate risk, et cetera. Does it make sense for them to take on that risk when we're at a time when yields are so high on what people would probably describe as more safe, plain, vanilla, developed market fixed- income assets, like US treasuries and investment grade credit. So I just want to put that question out there. You don't have to answer it now, but I want to come back to that and I want to explore a bunch of these risks. Let's come back to that question at the end, if that makes sense to you.

Dr. Ricardo Adrogue: Sounds good.

Greg Campion: Okay, cool. So let's start with political risks. Gosh, it seems like this year has just been so busy from a political calendar, and as we know, we're not done yet. And that's both in emerging markets and developed markets. So let's start on EM side. I know when coming into this year, there was a lot of focus and concern that, oh my gosh, there are so many EM countries going to the polls this year. So we're halfway through the year now. Can you give us an update in terms of where we are and how you're thinking about that EM political risk broadly?

Dr. Ricardo Adrogue: When we think about the political risk in EM, I would say we are looking almost in a rearview mirror. Elections in EM are pretty much done. Not all of them have been positive, at least not the results of the elections. We had had elections in Mexico, the bigger ones, election in Mexico, India, South Africa. Those are big markets, big countries. And in almost all cases, there has been surprises. Now, those are all passed, and as the governments get formed in all three, it seems that the outcomes have been more on the positive side than the negative side. And when we look forward, we still have the major election on EDM, but in the US, which is likely to shape the world politics and geopolitics. But from an emerging market perspective, the political risk, I would say, is highly diminished.

Greg Campion: Okay, that's great context. So if you think about those ones that you mentioned, were there any ones that were particularly worrying going into it? I'm just curious how they've worked out. So it seems like you're a little more comfortable generally speaking with how the governments have formed in some of these countries, but any ones that jump out in particular?

Dr. Ricardo Adrogue: So those three that I mentioned, Mexico, South Africa, and India, were the ones that most markets were the most focused on. And in all three, compared to the most recent polls before the elections, we did see outcomes that were unexpected. If we start by Mexico, we had the win of an almost constitutional majority in the hands of a new incoming president after a president that has been extremely popular in which it's very difficult to transfer the political power, the political will of the people, to another person. Andrés Manuel López Obrador, the president of Mexico, was able to transfer that political power to his big successor, Claudia Sheinbaum, and this new president of Mexico will have an almost constitutional majority. That wasn't expected. Everybody in the market was expecting that she was going to win, but the constitutional powers that she effectively will have was completely unexpected. So that is-

Greg Campion: Okay. Is that a good thing or a bad thing? Because sometimes gridlock-

Dr. Ricardo Adrogue: That's a bad thing.

Greg Campion: Okay, yeah, because I was going to say sometimes gridlock is a good thing, right?

Dr. Ricardo Adrogue: We tend to think, from a market perspective, that change and potential radical change and the ability to make quick change and unexpected change is negative. We prefer to see the evolution, not revolution, and somebody that has political powers to change the constitution effectively has the ability to do revolution. And in the case of Mexico, the revolution is the elected or the election of the judiciary from the top court to all the judges. That would create the one branch of government that is the weakest to be subject to political influence, and so that is very negative long- term. Now, the appointments that she has made has been quite constructive, quite positive, and her own background is quite positive. She's a scientist. She seems to be somebody that is independent from the previous president, Andrés Manuel López Obrador. And in Mexico, the president does carry a lot of power. So even when Andrés Manuel López Obrador, or AMLO, is the most prestige, the most popular political figure in Mexico, his power will wane and she will have the ability to shape the government in ways that are somewhat independent from AMLO. So that part is what the markets seem to be focusing on more recently, and that is relatively positive.

Greg Campion: Okay, got it. How about the other two countries? Anything you would want to say there?

Dr. Ricardo Adrogue: So in India, the surprise was right before the elections, the market was expected and the polls were saying that Modi was going to win a landslide, and the surprise was he didn't. Now, as a market participant, we perceive and we believe that having evolution is better than revolution, and therefore having Modi that has to govern with others is a positive. And the market seems to be already pricing that as well. The market seems to be moving in that direction. That doesn't mean that India will grow significantly less. It probably does mean that reform will need to be negotiated and potentially will be slower in coming. But India is in a very good path. India is growing really well. And in the case of South Africa, the ANC, the African National Congress, lost the majority that it has enjoyed since apartheid came down since 1994. This is a big break and the fear was that the ANC was going to side with the extreme left and the result has been that the ANC is now a center- left party and has aligned itself with the center party, the DA, Democratic Alliance, in South Africa. And so this is a really very good development for South Africa. Policies will be, seems to be, more consistent. And one of the problems that South Africa had had was the back and forth in the political spectrum, never moving forward because the ANC wouldn't agree on any policy because it was dominated by two factions, the right on the left. Now the left of the ANC has moved out through the EFF several years ago, the Economic Freedom Fighters, and through the Zuma party that he created very recently about six to nine months ago. So now we have more of a traditional center- left, but quite center, political domination in South Africa that hopefully will move the country forward.

Greg Campion: Okay, okay. So if we zoom out, and let's say you're an investor in these markets, but maybe you're not necessarily following the day- to- day political events, so if we zoom out, like I said, I think big concerns coming into this year, while it's such a packed EM election calendar, you just mentioned several countries where the elections are behind us now, like you said, not all perfect outcomes, so to speak, but it seems like something you can at least work with as an investor and a bit more clarity, I think, which is always helpful as an investor. Is there anything out there still on the calendar from the EM election side or political side? Is there any big thing you're watching or is it most of it behind us at this stage?

Dr. Ricardo Adrogue: Most of it is behind us. We do have municipal elections in Brazil, but those are unlikely to change anything. And the rest of the countries where there are elections are not really significant from a broad perspective in emerging markets.

Greg Campion: Got it. Okay. So let's shift to talk about developed markets because those elections, at least the one here in the US, is absolutely not behind us as we all know. It's been a very tumultuous time across developed markets and we won't get... That's beyond the scope of this conversation, but I think we've all been watching some of the shifts that we've seen in France recently, some of the shifts that we've just seen in the UK, some of them pretty surprising and unexpected. So let's talk a little bit about that. I assume that the US election is the most influential of the bunch, but maybe that is just my American bias coming through, I don't know, but let's talk about it. And what I'd like to do is get your opinion on what does a Trump victory look like, especially from the perspective of somebody investing in emerging markets, and what does a Biden victory look like? Now, I will caveat this question with the fact that we usually have a few days between when we record one of these podcasts and when it's actually published. Today, those are the two candidates for this election, so I guess we can talk in those terms. Could that change today? It looks like the one that's less certain is Biden. So if you want to talk in terms of a Democratic Party candidate win, I just want to throw that caveat out there, but how would you approach that and how are you and the team thinking about the US election broadly and how it may impact the landscape for EMs?

Dr. Ricardo Adrogue: The election in the US, as you said, is the most significant from a perspective of emerging markets, and in general, from almost any investor's perspective, the outcome of which, as you said, is open. The path of the US, from an investor that doesn't invest directly in the US, is not going to be very different. Both a Democratic victory or a Trump victory are likely to have the same lines when it comes to China. A Trump victory might be a little bit more aggressive, but the relationship with China is something that both sides seem to agree on. The decoupling from China, the decision that China had become a rival and needs to be considered as such and try to be brought down in economic terms, that will continue. The relationship with immigration, we know that President Trump is likely to be more constraining on immigration and that potentially can have bigger effects on US from an inflation perspective. All else equal, less immigrants at the time that the labor force is tight means wages tend to go higher, which is something good for the labor force in the US, but it could potentially turn into negative effects on inflation, negative as in higher inflation. But from an emerging market perspective, that higher inflation doesn't necessarily is a bad thing. Yes, it means potentially higher US nominal rates, but not necessarily higher real rates, which at the end of the day, is what counts for us who are emerging market investors. And then other policies, like taxes on imports, tariffs, those are certainly not positive from an emerging market perspective and, all else equal again, would translate into a potentially stronger US dollar. But when we look at what will or what has been the effect of the first presidency of President Trump, we come to the conclusion that we shouldn't take it for granted that the US dollar will strengthen on the back of a Trump presidency. Now, a Biden or Democratic presidency could potentially be the continuation of the current trends, which means inflation continue to come down. I'm not saying inflation will not come down under President Trump, but potentially it will be slower to come down. Interest rates in the US and in the rest of the world are likely to continue or start coming down for those countries in which they haven't yet come down. So the general environment under either presidency, a Democratic or Trump presidency, for an emerging market perspective is quite, this time I think, is quite uneventful. It's more significant for China, but for the rest of the emerging markets, it shouldn't be too problematic.

Greg Campion: Okay, okay. Now, as somebody who has, in a prior life, worked for the IMF and is very knowledgeable about all things macro rates, inflation, I'm very curious your view on where we go with the Fed and the Fed's independence and what the implications would be if the Fed became a more politicized institution.

Dr. Ricardo Adrogue: That's only a big risk, mostly because it would slide into the type of risk that we see in emerging markets where the presidency or the executive power wants to control all aspects of the economy, in particular monetary policy. And historically, especially in emerging markets, what we have seen is when the executive starts calling the shot on monetary policy, then the characteristic tends to steepen the risk aversion and the inflation risks start to go up. Now, the US doesn't have it in the law, a proper independence of the Fed. So in theory, there is an opening there for the presidency of the US to become significantly more involved in the Fed. So that's a big risk. At the same time, the US political system is one in which, through Congress and the congressional independence, it does provide for a check and balance to the executive power. And at the end of the day, the Fed responds to Congress. Congress is basically the one that basically decides on how the Fed should be run. And we have seen in the first presidency of President Trump when he tried to appoint several people to the board that they didn't clear the filter of Congress. So it is a risk. We believe that is a risk that needs to be priced in. It does create higher potential interest rates in the US because of that risk premium that I mentioned, the potential inflationary risk premium. And the way it works is simple. If you set rates to be too low to try to promote economic activity, all you're doing is basically in the long run creating more inflation because you're effectively pushing the economy to grow above potential. So it's not a political statement, it's just that it's basically a known economic fact.

Greg Campion: Yep. You're pulling growth forward essentially.

Dr. Ricardo Adrogue: You're trying to pull growth forward. It's what is traditionally called a populist type of policy that by bringing growth forward, you get people to be excited. It's sort of a sugar high, and then you have the consequences with high inflation, low growth, basically the 1970s in the US.

Greg Campion: Got it, okay. Well, something to keep an eye on, for sure. And we've just seen Chairman Powell sitting in front of Congress and getting lots of questions of, " When are you lowering rates?" And so there's clearly a political element, so it'll be a question of how much political influence the president, Congress, et cetera ends up having on the central bank. Something to watch, for sure. Let me just ask you this in terms of what's priced in or even how you and the team are thinking about hedging risk in such an environment. So if you think about we've got the election on November 5th, are you thinking that way? I mean, you think about what the polls show you today, it would indicate a Trump victory. So if markets are efficient in terms of pricing and expected outcomes, in theory, that should already be priced in. I don't know if you think it is or not, but how are you and the team just thinking about just that actual event risk around the election or is that something that you feel like you can look through?

Dr. Ricardo Adrogue: It's difficult to say we can look through. It is a monumental event. President Trump will be disruptive. What makes it difficult is that it's difficult to know how disruptive, and disruptive doesn't necessarily mean a bad thing. It's just it will make change. And because we don't know which way he will decide to go, it is difficult to foresee where one could get hurt as an investor. Now, there's some key indicators. The more a country is related to the US, like in Mexico, is at higher risk from a Trump presidency than a country like Brazil or a country like South Africa. From that perspective, one has some ideas on where one wants to stay, a little bit lower in risk than one would've been had that risk known in there.

Greg Campion: Okay. So is it as simple as looking at who are the EMs who have the US as their biggest trading partner? And if tariffs go up, I mean, is that the sort of analysis you're doing or is it-

Dr. Ricardo Adrogue: That's the first step, yes. And the next one is political links, and then second- round effects of those political decisions in the US. So Mexico is one, Europe is another one, I mentioned already Asia, particularly China. Now, the fact that the US has taken on China, from an emerging market perspective, and this is something that the markets haven't yet caught on to, is not necessarily negative because basically the US is knocking out the biggest competitor that emerging markets had. Emerging markets in the last 20, 25 years have seen imports going into China for China to manufacture goods to sell into the US and Europe. Well, now the US is saying, " We don't really want to buy a lot of Chinese goods because for geopolitical reasons, because of rivalry, and also because of policies that are not really fair from the way the US understands economic policies." Europe is starting to do the same thing. So that creates lots of opportunities within all the other emerging market countries, and even China is realizing that by shipping some of their productive capacity into countries like Mexico and other emerging markets.

Greg Campion: Interesting. Okay. Something to keep an eye on. All right, let's zoom out from political risk and let's talk a little bit about geopolitical risks. This is something that's been very much on investors' minds as we look at a lot of the tragic situations that we have around the world with Israel- Hamas, we've got Russia- Ukraine, you already mentioned different geopolitical flashpoints with China. Can I just ask you again within the overall context of assessing risk for emerging markets relative to developed markets, can I just ask you how you and the team are trying to get your arms around these risks? And I'm just curious as you look at, okay, let's look at how we expect the Russia- Ukraine situation to develop over time, what does that mean, for instance, for some of the other Central and Eastern European countries? Are they investible, non- investible? It's a big question, but how are you and the team thinking about these risks broadly and how are you getting your arms around them?

Dr. Ricardo Adrogue: So when we think about geopolitical risks, we realize that there's some specific areas that are highly affected by these political risks. And if I name them from least advertised to most significant in the general press, we have China and the Philippines, that they have been highlighting the risk that China is causing in the South China Sea and the whole Asian region, including North Korea, though North Korea seems to be more related to Russia these days. Then we have Israel and Hamas, which potentially could be expanding to Hezbollah. And then we have Russia and Ukraine. Now, as investors, we don't have any particular knowledge, as far as we can tell, about how these things can evolve. We can have scenarios, we can have our own perceptions, but the way we like to invest is bottom- up. And when we look at top- down, we say, " Well, if we have those risks, where can we hide from those risks or how we should minimize those risks in our portfolios?" And where do we hide? Where we find the most value these days is in Latin America and Africa. And the one thing I would add within this is one risk that we have been highlighting in previous podcasts is the IMF and the desire of the IMF to push countries into default is something that we have mentioned several times before. We have seen how those countries have come through the restructuring process. We had Suriname some quarters ago, then we had Zambia, now we have Ghana, that appears to have reached an agreement, and hopefully soon we will have Sri Lanka. So there has been a change and the market for a little while appears to have priced that in, meaning the risk of the faults in emerging markets being pushed by the international community, and specifically the IMF and the World Bank. And now those risks seem to be receding and the spread, especially on the high- yield component of the market, look quite attractive at 700- plus basis points over US Treasuries. And some of those countries, as you heard, are in Africa and in Latin America.

Greg Campion: Okay, okay. Well, that makes a lot of sense. Yeah, I mean, I can imagine it's difficult if not impossible to predict how some of these geopolitical situations are going to turn out. So if you can construct your portfolio such that you're not directly exposed, that seems like a smart way to do it. Let's talk a little bit about interest rates. Interest rates are so important. We talked a little bit earlier about the independence of the Fed. We've been in this higher- for- longer regime for most of this year, but it seems like maybe we're close to an inflection point here, at least in the US. We're seeing some signs, I guess, of maybe a slower job market. The inflation data is pretty noisy, but we're seeing perhaps inflation easing a bit, and all of a sudden the prospect for rate cuts are back on the agenda. I think markets are starting to price in a September rate cut as we sit here today in July. So talk to me just a little bit about how this current interest rate backdrop in developed markets impacts and feeds through to the attractiveness of EM debt.

Dr. Ricardo Adrogue: Historically, when the Fed is done hiking rates, it has been one of the best times to go into emerging market investments. When you look at today's markets, a lot of investors are a little concerned because they feel that the spreads that they can get in emerging markets versus their own histories, they do not look as attractive. They look, what they call, tight compared to history. Now, that could be a little bit misleading and one of the things that we like to highlight is the fact that at higher US rates and global interest rates, the market risk involving those spreads is lower. So when interest rates in the US were zero or very close to zero, the spread of 150 basis points had to include an amount of market risk, meaning the overall market moving up or down that, relative to zero, is much bigger than when interest rates are at 5%. So the spreads in emerging markets naturally because of market risk should be smaller now or should be lower now than they were back then. So that in itself means spreads that appear to be tied, historically speaking, are not as tight. And then when you compare those spreads to the actual default risks, they way overcompensate for default risk. And the last thing I would say is that when you actually look at US interest rates, and not necessarily the overnight interest rate, but the medium term, the 10-year rate to try to avoid the near- term noise, the US rates are not anymore one of the lowest ones in the world. If you make a long list of developed and emerging market interest rates at the 10- year level nominal rate, the US is stuck right in the middle. Furthermore, the US is the second- highest 10- year nominal rate in the world, the developed market world. New Zealand, as of the last time I looked, was higher, but everybody else had lower 10- year rates. And as you mentioned, we have, based on everything, every indicator that we get, have gone through this timing cycle and the next cycle is easing. Emerging markets did it a year ago. The developed markets are a year behind, but they're clearly going that direction. I will make one last statement, and it may be early, but I think inflation is dead.

Greg Campion: Bold. Okay. Well, you can't just throw that out there without giving some reasons why. What makes you think that?

Dr. Ricardo Adrogue: I wanted a headline. There are obviously risks. We mentioned the political risks, we mentioned taxes, immigration, other policies that can affect inflation, particularly in the US, going higher. But when you actually look at economic data releases and you actually look at what central banks have done, what we have experienced is a global timing cycle, started that with emerging markets, followed by developed markets, the emerging markets started easing, but the emerging markets overall don't really come for global inflation. And then now we're about to see developed markets easing. On top of that, we had because of the policies that have been implemented against China by Europe and the US, what we have seen is a China that is doubling down on its historical policies, meaning what China knows how to do is to basically create, produce, not really consume. And so when China has been pushed, what they are best at doing is trying to produce more at cheaper and cheaper prices. And that has been happening since Mao's days. And this presidency, President Xi Jinping, seems to be following the same path. They talk the idea of increasing consumption in China, but their policies are basically oriented to producing, producing goods, producing services, trying to export, always trying to get the rest of the world to buy their goods so that they can grow.

Greg Campion: You pointed out that traditionally or historically emerging markets debt has done well when the Fed finishes their hiking cycle. It appears that we are at that point now. You mentioned that credit spreads are not indicative, you think, of default risk in EM sovereign debt. And in fact, your colleagues just put out a paper called, " EM Sovereign Debt: Spreads Are Tight... So What?" Very spicy, clickable title. And then you made a very bold statement and you said you think inflation is dead. So I think there's a future article under your name coming that inflation is dead, so we should talk afterwards about that one. So that, I guess, is a great segue to my final question, which was in fact my first question, which is within the context, I guess, of everything we were just talking about, if you're a developed market investor today, and over the last couple of years you've said, " Hey, EMs, why take the additional risk? Yields are chunky here at home, don't have to take all that risk, not a lot of incentive to do that," so come back, close this out for us and I'd like to get your answer on that within the context of everything we just talked about. Does it make sense for developed market investors to invest in emerging market debt today? And if so, where do you see the most compelling value opportunities?

Dr. Ricardo Adrogue: So developed market rates are higher, and by itself, present on the face of it what appears to be a more attractive opportunity than in the past, and relatively speaking, with spreads, as we mentioned, being tight, you say, " Well, why go into emerging markets?" We gave some answers. We said, " Well, spreads overcompensate for the fall," but you are hitting at the core of what a lot of investors are dealing with today. They have been saying, " Why invest in what appears to be something riskier?" Now, when you actually take a step back and you realize where prices and valuations are, you come to a conclusion as almost an outside onlooker into this situation that risk aversion has gone a little too far, meaning the market seems to be ignoring the risks that are present in developed markets and that they have been diminished in emerging markets, specifically fiscal dynamics in countries like the US, countries like France, countries that are core to developed markets. So underlying those interest rates, there is a reason for those interest rates to be higher. These countries will need financing for a long time to come, and neither one seems to be interested in doing a true fiscal adjustment. On the other hand, you have countries in emerging markets that are borrowing in those foreign currencies in US dollars effectively that offer you a premium spread that really don't need to borrow in those markets because they have their own markets. And so that's almost a free premium, a free gift that they're giving. So that spread, it's certainly a good place to be. Now, the other component is, well, valuation. Within emerging markets, what are the things that we think are the most attractive? The one that stands out is local interest rates because when you adjust those by inflation, they're extremely high, very attractive. The problem is you cannot buy interest rates without buying the currency, and the currency tends to stop people because if you look at the last 10 years, 12 years, emerging market currencies have not done well. Now, that in itself should be a reason why maybe having some foreign currency exposure makes sense. That is not what appears to be in the forefront of investors' minds these days. They tend to look at the US dollar debt, US dollar emerging market debt, and we do find quite a bit of value. We said that spreads overcompensate for the fall. The high- yield component of sovereign debt, as I mentioned, that included that risk premium because of the defaults should be fading. And so that in itself is a very attractive proposition, and we're talking about 720 basis points or 700- plus basis points in spread of high- yield over US Treasuries in that sense. That is a very, very juicy spread. So local interest rates is the top priority if you can take the currency risk because you cannot completely separate it. Second is the spreads, especially the high- yield, inaudible spreads. And third is currencies. They do offer value and they do still offer carry.

Greg Campion: Yeah, great. Well, I'm not going to try to recap all of that, but I think that was a great way to end it. It sounds like there's some really attractive opportunities, some very attractive yields on offer, and it sounds so attractive that they may in fact compensate for some of these risks that we spent so much of this conversation talking about. So there will be plenty to watch in the months ahead, and I have a feeling we may convince you to get back on our outlook for the 2025 outlook, which we'll be doing in November, and I think we may know the results of the US election by then. We'll see. But until then, Ricardo, this has been a pleasure. Thanks so much for your time.

Dr. Ricardo Adrogue: Thank you very much for having me.

Greg Campion: Thanks again for listening to or watching this episode of Streaming Income. If you'd like to stay up to date on our latest thoughts on asset classes ranging from high- yield and private credit to real estate debt and equity, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. And if you have specific feedback, you can email us at podcast @ barings. com. That's podcast at B- A- R- I- N- G- S dot- com. Thanks again for listening and see you next time.