Emerging Markets Debt: An Early Spring?

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This is a podcast episode titled, Emerging Markets Debt: An Early Spring?. The summary for this episode is: <p>Ricardo Adrogue, Head of Global Sovereign Debt and Currencies discusses the Barings' team's increasingly positive view on the outlook for emerging markets debt. </p><p><br></p><p><strong>Episode Segments:</strong></p><p><br></p><p>(02:21) - Reasons to be optimistic about EM Debt in 2023</p><p>(04:28) - The tug of war shaping global economic growth</p><p>(07:15) - A multi-speed global economy in 2023</p><p>(08:40) - Why inflation may fall faster than expected</p><p>(14:40) - The EM rate picture and a potentially weaker dollar</p><p>(18:49) - The outlook for credit vs. rates</p><p>(20:04) - Assessing the major geopolitical risks in EMs today</p><p>(25:34) - The risk that China's re-opening disappoints</p><p>(29:16) - Why the IMF's changing view on defaults is a risk</p><p>(33:57) - Where the most attractive value lies in EM today</p><p><br></p><p>Links to recent papers referenced in the podcast: </p><p><br></p><ul><li><a href="https://www.barings.com/perspectives/viewpoints/emerging-markets-debt-springtime-in-january" rel="noopener noreferrer" target="_blank">Emerging Markets Debt: Springtime in January?</a></li><li><a href="https://www.barings.com/perspectives/investment-institute/why-quantitative-tightening-could-make-quick-work-on-inflation" rel="noopener noreferrer" target="_blank">Why Quantitative Tightening Could Make Quick Work On Inflation</a></li></ul><p><br></p><p>IMPORTANT INFORMATION</p><p><br></p><p>Any forecasts in this podcast are based upon Barings’ opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Investment involves risk. The value of any investments and any income generated may go down as well as up and is not guaranteed. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Any examples set forth in this podcast are provided for illustrative purposes only and are not indicative of any future investment results or investments. The composition, size of, and risks associated with an investment may differ substantially from any examples set forth in this podcast. No representation is made that an investment will be profitable or will not incur losses. </p><p><br></p><p>Barings is the brand name for the worldwide asset management and associated businesses of Barings LLC and its global affiliates. Barings Securities LLC, Barings (U.K.) Limited, Barings Global Advisers Limited, Barings Australia Pty Ltd, Barings Japan Limited, Barings Real Estate Advisers Europe Finance LLP, BREAE AIFM LLP, Baring Asset Management Limited, Baring International Investment Limited, Baring Fund Managers Limited, Baring International Fund Managers (Ireland) Limited, Baring Asset Management (Asia) Limited, Baring SICE (Taiwan) Limited, Baring Asset Management Switzerland Sarl, and Baring Asset Management Korea Limited each are affiliated financial service companies owned by Barings LLC (each, individually, an “Affiliate”).</p><p><br></p><p>NO OFFER: The podcast is for informational purposes only and is not an offer or solicitation for the purchase or sale of any financial instrument or service in any jurisdiction. The material herein was prepared without any consideration of the investment objectives, financial situation or particular needs of anyone who may receive it. This podcast is not, and must not be treated as, investment advice, an investment recommendation, investment research, or a recommendation about the suitability or appropriateness of any security, commodity, investment, or particular investment strategy.</p><p><br></p><p>Unless otherwise mentioned, the views contained in this podcast are those of Barings and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. Parts of this podcast may be based on information received from sources we believe to be reliable. Although every effort is taken to ensure that the information contained in this podcast is accurate, Barings makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information</p><p><br></p><p>Any service, security, investment or product outlined in this podcast may not be suitable for a prospective investor or available in their jurisdiction.</p><p><br></p><p>Copyright in this podcast is owned by Barings. Information in this podcast may be used for your own personal use, but may not be altered, reproduced or distributed without Barings’ consent.</p><p><br></p><p>23-2695598</p>

Greg Campion: After a difficult couple of years for emerging markets debt and risk assets more generally, could the picture finally be brightening? With the end of the Fed's tightening cycle potentially in sight and COVID restrictions being lifted In China, there are reasons to be optimistic.

Ricardo Adrogué: And when we look forward, we see a world that it's difficult to see being as bad as the previous years. That's a very low bar, but it is a bar that we think we will clear quite easily. And the potential is that growth will not be as bad, but we will slow down helping inflation to come down, and the geopolitical problems potentially will take a little bit of a step back. In that environment, the Fed at some point will pivot, all central banks in the world that have been so aggressively hiking rates to contain inflation will potentially start to realize that their policies played out, and the world will be a better place.

Greg Campion: That Was Ricardo Adrogué, 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 today's show, the brightening picture for emerging markets debt, how trends in inflation, economic growth, monetary policy, and even geopolitics may be setting the stage for a favorable environment in 2023. Ricardo, welcome back to the podcast.

Ricardo Adrogué: Thank you. It's a pleasure to be here.

Greg Campion: I'm excited to have you here. I understand I've just got you on the back of your trip back home to Argentina. So curious what the mood was there, especially after the World Cup victory.

Ricardo Adrogué: Lots of excitement, very happy, the country together behind the team. Economically speaking and institutionally speaking, not as positive. People are not happy with politics, people generally are not happy with the politics.

Greg Campion: Yeah. Well, at least they've got-

Ricardo Adrogué: At least they have the World Cup.

Greg Campion: At they have a World Cup champion and they can celebrate Mr. Messi for many years to come.

Ricardo Adrogué: inaudible.

Greg Campion: Yeah. Well, great. So I wanted to have you here to start off the year to get into talking about what the outlook could look like for emerging markets debt heading into 2023. You and the team put out a piece right at the end of last year that expressed a pretty positive view on the asset class, which I don't know if it's non- consensus or not, but it is different from at least what we've been seeing in the asset class the last couple years. It's been a very challenged environment. We've had COVID, we've had higher rates, we've had geopolitical issues. A lot of risks to worry about and it's really weighed on emerging markets debt across all the various flavors of that over the last two years. So talk to me a little bit about why you're feeling a little bit more optimistic today.

Ricardo Adrogué: So Greg, I think you hit it on the nose. The last couple of years or even more than a couple of years, emerging markets and a lot of other risky assets have been under a lot of pressure. And that pressure has come, as you pointed out, from geopolitics, from COVID, from rate rises, inflation. And when we look forward and we realize that markets are forward- looking, we see a world that it's difficult to see it being as bad as the previous years. That's a very low bar, but it is a bar that we think we will clear quite easily. And the potential is that growth will not be as bad, but it will slow down, helping inflation to come down. And the geopolitical problems potential will take a little bit of a step back. That's what we're feeling the least comfortable or the least confident about on geopolitics, but the other two are pretty clear. And in that environment, the Fed at some point will pivot, all central banks in the world that have been so aggressively hiking rates to contain inflation will potentially start to realize that their policies played out, and the world will be a better place.

Greg Campion: All right. Well, I like the optimism, so let's dig into some of those in a little bit more detail. So maybe let's start with the economic growth picture. So it seems to me listening to different prognosticators around the market, you've kind of almost have a tug of war going on right now where you have in the West, you've got obviously almost a year into this rate- hike cycle, pretty aggressive rate- hike cycle. Now, arguably not all of the effects of those higher rates have filtered their way into the economy, so you've got that potential headwind on the horizon as we head through 2023. And I think it's why a lot of people have been calling for a recession, whether it's sometime this year or maybe even gets pushed further out to the right next year. You got that on one side. On the other side you've got the China bulls really saying, " Hey listen, this is a second largest economy in the world. It's been hamstrung by pretty strict COVID policies over the last several years, and that is looking like it is now opening up." So pretty interesting tug of war there. How does that play out in your mind?

Ricardo Adrogué: So as you pointed out, China reopening should be very helpful to reigniting global growth. The US recession and the Western hemisphere, if you will, Europe, US, and potentially some other economies, Australia and others, potential recession or slowdown should help cool inflation. But the one thing I would point out is that a lot of market participants have been calling for recession because financial conditions have tightened law. When you look at mortgage rates in the US back to the levels that we haven't seen since 2007 before the great financial crisis, those are really very, very high mortgage rates. And that's just to point one indicator that highlights how tight the financial conditions are. And so the natural implication would be with these conditions, economies are likely to have a very severe recession. At the same time, others have pointed out how strong balance sheets of consumers and companies have been, and so that could potentially cushion. And one thing that nobody mentions is that because of the geopolitical tensions, a lot of countries have ramped up military spending, and military spending is a great multiplier in these economies, it's potentially not a great ESG component, but it does produce economic activity. So when we look at the numbers that have been coming out of Europe or the US, we come to the conclusion that there's something more going on than just the financial tightening and the potential severe recession. There is activity that has been a little bit more resilient that that tightening would have suggested.

Greg Campion: So as you think about this growth picture and how it could play out, it suggests that you're seeing not a very even environment around the world. There are different countries that may be going into recession, coming out of recession, different countries operating at different speeds. So how do you think about that and does trade play a role there and tourism? I know you've written about those recently.

Ricardo Adrogué: Yeah, so the way we look at it is the global economy is likely to slow down even if China reaccelerates. China has had a really difficult 2022, and so the economy of China is likely to reaccelerate this year because of the opening, reopening, the rest of the world is likely to slow down. Because of the slowing of the rest of the world, and because of geopolitical tensions, trade is likely to not be the first engine of growth, global growth. We do think that tourism that has started to pick up since COVID quite aggressively and especially with the reopening of China, is likely to really take off and be potentially the first engine of global activity or transmission of global activity across countries. We try taking the second step, potentially the second half of the year or maybe in 2024 as the global economy reengages with more or higher growth.

Greg Campion: And just I guess back to monetary policy and thinking about how that all plays out. So it seems like potentially we're getting toward the end of a tightening cycle here. You mentioned the word pivot upfront. It seems unlikely given the messaging that you're seeing from central banks so far that an easing cycle is on the way anytime soon, but perhaps it's an end of the tightening cycle. So tell me about how you're thinking about that, and then related to that is inflation. So you wrote a piece last year where you made the argument basically that inflation could come down much faster than is currently expected by the market. So let's talk a little bit about what you think central bankers are looking at and when they may end this tightening cycle and then how inflation factors into all of that?

Ricardo Adrogué: So the perception that I have is that central bankers have been surprised, negatively surprised, by the big spike in inflation. The best minds in the profession, in the economic profession, both at the US Treasury, the US Fed, the IMF, the World Bank, other central bankers, have not foreseen this inflation spike. And so their first order of priority is to bring it down, they realize how bad inflation is long term, and especially Jerome Powell has been very vocal about it, they need to bring it down. So they have been very aggressive in their rhetoric and they have a tool that they know has worked really well in the past, which is interest rates. And they have high interest rates and they have announced future hikes and they have said, " The terminal rate will be higher and we will bring inflation down effectively." That's what they are saying, " And we don't care whether that causes recession and all of it." Now there's a second component, which is the one that we have focused on is the quantitative timing. And the problem with quantitative timing is that there has been a lot of effort at trying to understand how to translate quantitative time or in general money, quantity of money, with an equivalent interest rate level. And very little has been published and talking to friends and colleagues from my prior places, especially the IMF, their take is that nobody can find any relationship. And so the natural conclusion by policymakers is that really the quality of money plays absolutely no role in monetary policy. Our take, my take in the piece that we published months ago has been that when you actually look at broader and longer terms, the quality of money appears to have been a pretty big determinant on inflation. And when we followed that through, given the quantitative timing that has been announced, then inflation this year could potentially come close to collapsing because the Fed is withdrawing a lot of money from the system. And so that's the conclusion, the risk is that central bankers may end up doing a little too much, a little bit again.

Greg Campion: Okay. And we'll link to that piece where you laid out that full analysis in the show notes of the podcast, but at the time, and I think you published that in August, at the time you said that you thought that inflation could fall below 2% by late 2023. Here we are, early 2023. Are you still thinking that that is roughly about right? Does that analysis still hold? I guess I'm asking you.

Ricardo Adrogué: I would say yes. Now, it is important to realize that that's one piece of analysis. It is also important to realize that the inflation dynamics, nobody understands them fully, not even the best central bankers. And I won't pretend that I have the full answer to the inflation problem, but based on that analysis, I still think that inflation could fall below 2%, which would be a big surprise to the markets.

Greg Campion: Not a forecast just to be clear, but more a really interesting analysis pointing out something that maybe is being underappreciated, and that's the effects of quantitative tightening. And that has not been as well observed or studied as a tool like the interest rate policy.

Ricardo Adrogué: Yeah. And I would go one step further, I would say it helped explain the spike in inflation, the increase in inflation that we have seen in 2021 and 2022 much better than central banks had predicted it.

Greg Campion: Okay. So as you move through 2023 and you are obviously managing portfolios of sovereign debt and interest rates, currencies, as you go through that, what signals are you going to personally be watching to tell you if that thesis is playing out or not?

Ricardo Adrogué: The main one is the slowdown in the US economy, and related to that, the inflation dynamics that take place. So every time a CPA comes out, the Barings Institute produces a report in which they show where, what are the key drivers of that inflation number? And we find those, and I find those extremely useful to the extent that inflation is concentrated on a few things that, like for example, shelter that is sort of an input that doesn't really fully reflect the dynamics of the economy and the domestic demand that can be taken out. And the rest of the inflation components are starting to suggest that potential inflation could slow down quite aggressively, quite significantly over the next few months.

Greg Campion: Okay. And obviously central bankers will be seeing that data and maybe that leads to an end of the tightening cycle sooner than later. So as you think about that, so if you think about if we're coming to the end of a tightening cycle, I'm curious about two things. One, where emerging markets are in their monetary policy cycles and how that factors in? And then two, we've been living in this strong dollar world for several years now. Do we see that reverse, and could that ultimately be a tailwind for emerging market portfolios like the ones you manage?

Ricardo Adrogué: Emerging market central banks have been ahead of most of the developed market interest rate hikes. One could argue that emerging market center banks are ahead of the curve or have been ahead of the curve, and naturally the implication would be that they could potentially be the first ones to start cutting rates. It is difficult to conclude necessarily that emerging market central banks will start cutting before the Fed because for the most part, emerging market monetary policies are not as developed and they tend to follow rather than lead. And so they have led on the hikes, they potentially could lead on the cuts, but our call is even if they don't lead on the cuts, they will most likely be or start cutting at the same time as the Fed. And so that means that a lot of these currencies, emerging market currencies, could potentially start looking very attractive. They have very high carry, interest rates in emerging markets are significantly higher than developed markets. It is quite clear that even if developed market rates may go higher in the near term, emerging market rates don't have a lot more to go on the upside. And so that tends to be a really good time for currencies to appreciate. At the same time, emerging markets, central banks do need currency appreciation to combat inflation. And so unlike previous times when their currency appreciations were not welcomed by central banks, and such central banks intervene to prevent it, this time they're welcoming it because they need inflation to come down. So we could be at the beginnings of a positive cycle of valuations being attractive, attracting flows, inflows coming in, which in turn causes more appreciation of currencies and assets within emerging markets.

Greg Campion: Have you seen any evidence of flows into the asset class at this point or have flows been pretty negative?

Ricardo Adrogué: So when we wrote the piece, we hadn't seen that was, or we were in the very, very beginnings of seeing them.

Greg Campion: Yeah. This came out in mid- late December, I think, and we'll link to this piece as well.

Ricardo Adrogué: Yeah. And now we are starting to see pretty big jumps in allocations to emerging markets and in general to other risky assets as well.

Greg Campion: Do you think that's just a rebalancing coming into the new year and people are looking at their asset allocations and looking where valuations are and things like that and saying, " Okay, maybe the worst is behind us for emerging markets"? Does that play a role or do you think it's something else?

Ricardo Adrogué: I think so given the timing because through the end of December we have seen a slowdown in activity, evaluations were quite flat. And January started and the whole market, not just emerging markets, other risky assets started to take off.

Greg Campion: Sure. Yeah.

Ricardo Adrogué: So it seems to be some rebalancing. It seems to be related to the fact that we had such terrible two years that people potentially had been withdrawing from risky assets. Withdrawing, withdrawing, withdrawing, and they go to a point in which they say, " Well, wait a minute, it's potentially not time to continue to withdraw." And so just by that feature, risky assets start to revive.

Greg Campion: Yeah. Now, the only pushback that I see on that is, okay, if we are heading into a potential economic slowdown, at least in parts of the world, the US, Europe, etc., then does it make sense for it to be a risk on environment? I mean, I guess a lot of that's determined by what valuations look like, but how are you thinking about that? And I guess as you look at the potential sources of returns, so you think about emerging market debt, you've got a rate component, you've got a credit component in sovereign and corporate debt. Are you expecting one to outperform the other this year?

Ricardo Adrogué: So you, again, are pointing to the right question. Recessions are not good for credit. When recessions happen, companies have trouble selling their products, rolling over their debt, and sometimes falling into default. And when enough companies in a given country go into difficulties, the country goes into difficulties, and the country itself can go into default. So the natural implication would be for rates and currency in emerging markets and developed markets to take the lead in performance, especially in the first half of the year, and then only when the end of the recession is inside or the end of the slowdown is inside, credit to be taken the lead. Now, the truth is one has to put that in the context of valuation and some credit is valued too cheaply to be a pass even when a potential recession is ahead of us.

Greg Campion: The other thing you mentioned upfront was geopolitical risk. It's something that obviously we always need to take into consideration when investing in emerging markets, sometimes when investing in developed markets as well. There's some obvious flashpoints that everybody is focused on, the war in Ukraine, the protests that we saw in Brazil. So tell me just broadly how you're thinking about geopolitical risks today? And then maybe are there ones that have your attention in particular right now and how you and the team are trying to factor those into your analysis?

Ricardo Adrogué: So the traditional ones are the ones that are quite in the open. The Russian invasion of Ukraine is not clear when it's going to end, how it's going to end, where we are currently. Being in the middle of winter as we speak, appears that the war has taken a step back, but it's still ongoing. And we don't know which country will take the upper hand, we are reading all over the press about tanks or no tanks given to Ukraine to try to regain its territory. It's not clear, there's too many moving parts in that war. It's very difficult to know what the outcome will be in a way. And the difficult part of that is that it could potentially expand the effect of that war to other asset classes or even within emerging markets to potentially other countries. That is in the open, we don't think we have anything specific to out there.

Greg Campion: Yeah, yeah. But let me ask you this, I mean, outside of the obvious humanitarian disaster there that the world is watching. As an investor, how are you trying to navigate that? I mean, I think there's obvious things like avoiding... Or I don't think you're even able to invest in Russia, but how about that region broadly, how do you navigate that?

Ricardo Adrogué: So one way in which we have been looking at is the individual countries and how they align politically outside of the immediate sphere. So not just Ukraine, but looking into Serbia, looking into Romania, looking into Macedonia, looking into Bulgaria. Those countries initially could hit really hard on their bonds, the evaluation of their bonds. And initially may have been the perception that could potentially Russia could expand their military activities to countries outside of Ukraine. But very quickly was clear that it wasn't, but still those countries were pricing at levels that were not consistent with their macroeconomic fundamentals. So there was a big risk premium from a geopolitical component. And so the big effect there, the big focus there for us is how are they aligning? Are they siding with the EU or they're siding with Russia? They're in a very difficult position because being at the border effectively of the whole thing makes their decisions very monumental. They could determine whether the leadership survives politically and the country survives economically over the long run. Now, given that Russia seems to not have been able to achieve almost the minimum goals that it has set for itself in the invasion of Ukraine, most of these countries are gradually siding with Europe. And so that from an investor perspective is great news and that seems to be part of the good feel that the market is having, especially in the early parts of January.

Greg Campion: So are any of those countries in that region investible?

Ricardo Adrogué: Most of them are. We do like from a credit perspective, pretty much all of them. Macedonia, Romania, Serbia, Bulgaria has been coming to market. We have been doing quite extensive analysis on that. And then we have very solid investment grade credits like Poland. Hungary has its own geopolitical issues or ESG issues, rule of law and other stuff. But for the most part those are very, very good investible, high- quality credits.

Greg Campion: Got it. Okay. So the war in Ukraine, that's on everybody's radar screens. What else is not so obvious out there?

Ricardo Adrogué: Well, the second one that is pretty much in everybody's radar screen is China's reopening. And I think related to that is the geopolitical implications of Russia's innovation of Ukraine combined with Russia aligning with China, or China aligning with Russia. And that partnership of the two countries being quite solid, or appearing to be quite solid, is pushing investors to really withdraw from countries that may not be perceived as friendly and could potentially be subject to sanctions. The perception is that a lot of investors are already in that game, they know that that's a risk. And increasingly money that originates in Europe or the US, where the final saver is in those locations, or Japan, or Australia, gets invested outside of China and Russia. And money that is originated in China gets invested within China. There's not a lot of money in Russia for asset managers. So that's the second risk, but it's pretty much known. The third risk-

Greg Campion: Can I stop you there and just ask you on the China reopening? So do you think there's any risk that, I guess I'm curious how you and the team will be monitoring that to assess is this a real factor in terms of global economic growth? Because obviously there's so many impacts on emerging markets for China's growth story, but curious how you all will be monitoring that because one could play devil's advocate and say, " Hey, look, the reality is yes, they've taken off the COVID restrictions, but probably what's going to happen now is mass waves of COVID that's going to result in its own sort of shutdown of sorts and maybe you can't just flip a switch and re- accelerate the world's second largest economy from the get- go"? So how are you thinking about all that?

Ricardo Adrogué: So within the team, we have had discussions on what the reopening would mean, and I would say my take was a little bit the second part of your question, meaning COVID is more than just a policy decision, it's an individual decision. People decide, we have seen whether to go out or not to go out, whether to wear masks or not wear masks, how much you go out, how much you get exposed. And that has economic implications. If you don't go to work, production doesn't get done, and so the economy slows down. And there's so much a government as powerful as the Chinese government can do about it. If people say, " Well, I'm too afraid of COVID because I see the effects of it and I don't go to the factory," then the production doesn't take place. The truth is, so far we have not seen that effect. And we have people in the team that have relatives in China or they live in China, and the truth is they have taken it on their stride. They have accepted the fact that a lot of people are getting sick. So far we haven't heard of a lot of deaths, and some people believe that it's not as deadly. I personally have my question marks about it. So the way we will be monitoring is, as I mentioned, through the individuals that have family members in China, through the individuals in the office that we have in China, and also through the numbers that come out of outside of China, the interaction, the exports and imports into China. And I mentioned the export and imports into China and numbers outside of China because we do have a lot of trouble relying on Chinese figures a lot of times.

Greg Campion: Yeah. So some of the sort of second derivative data that's import/ export data that you're getting from their trading partners is a good indication of economic activity, is that-

Ricardo Adrogué: And tourist activity,

Greg Campion: Yeah. Okay.

Ricardo Adrogué: Chinese tourists are very important for a lot of countries, not just in the region, but broadly. Obviously China has a lot of citizens that were effectively locked in, they couldn't go out because of COVID restrictions. Now that they're being allowed, a lot of countries have required Chinese tourists to show COVID tests, but we think that that sooner or later, and most likely sooner, will be removed.

Greg Campion: Yeah, I think some of the luxury goods, publicly traded stocks have already started to reflect that, but I have the same sort of question or I don't know if you call it skepticism, but can you flip the switch and turn it right back on like that?

Ricardo Adrogué: Yeah.

Greg Campion: Okay. Sorry, I rudely interrupted you.

Ricardo Adrogué: No, no, no.

Greg Campion: You were going to make one more point around geopolitical risks that may not be as obvious.

Ricardo Adrogué: Yeah. The one that I think is the least obvious, which is something that we have been mentioning in our past reports and past conferences, is the IMF interaction with countries and risk of default. There is a perception, and I happened to visit the IMF yesterday and met with some former colleagues, there is a perception that the IMF has given up on trying to get countries to do the adjustments, financial adjustment, fiscal adjustments that are required to make those countries sustainable in the long run. And that is quite disturbing because there's a lot of movements to populism, and you mentioned the Brazil protests. And population takes different forms, but at the end of the day, it is an economic force that doesn't believe that there is budget constraints, that you can always ask for more and that should be given to you. And there's no limit to how much can be given or produced, which economically speaking, myself as an economist, know that that's not correct. We don't know exactly what is the limit, what is the budget constraint, but there is a budget constraint, there is a limit on how much. And so if the IMF has given up, then the natural implication is the IMF is saying, " Well, these countries are not adjusting, so these countries are not sustainable, so therefore these countries need to restructure." And the IMF is pushing that line very, very strong. And that is sort of a geopolitical risk that is playing out and that is affecting the valuation of the bonds in ways that is very difficult to price, because when you talk to government officials in the IMF, they say, " Well, people in the market should know how to price those." The problem is there's a permanent change of contracts, which makes it really very difficult to price that type of risk.

Greg Campion: Okay. So is this basically you and the team are maybe better well placed to analyze the ability of these countries to satisfy their debts? Does this get into the willingness to satisfy those debts?

Ricardo Adrogué: That's exactly right. Exactly, country's willingness to pay the debt. So ability to pay the debt is basically look at their balance sheet, look at the trends in growth, you look at... And then it comes to, " Well, is this country willing to pay for that date?" And unfortunately, small changes in willingness do have very large implications for sustainability. Economies like to talk about sovereign countries being sustainable or unsustainable, but when you actually look under the hood, very, very small changes in assumptions make very big differences in whether you consider a country to be sustainable from a financial perspective or not.

Greg Campion: Okay. So how do you and the team attempt to analyze that, or how do you factor that into where you're allocating capital?

Ricardo Adrogué: The main way is knowing the country, so we need to know the country. And that means knowing the history, knowing what tick the countries. It's seldom the case that the country makes big breaks in their policy making even with changes in government. So let me give you a very clear example or a recent example. Chile. In 2019, Chile had big riots. There was a big demand for a really big change. They called eventually for a constitutional reform, a constitution was presented. The population, that same population found that constitution to be too radical. So those same people that in 2019 said, " We won a new constitution." By 2022, despite COVID, despite all the hardships, came to the conclusion that yeah, they want change, but not as radical as was presented. And so I mentioned this because when you look at the country like Sri Lanka, a country that traditionally has been a high growing country that has followed very reasonable fiscal policies, that got hit really hard by COVID and tourism, and then elected a government that decided to go crazy, cut taxes, we think that that was potentially a temporary phenomenon that now has been amended. But that, what it takes is we need to know the country, we need to go to the country, we need to know the history of the country, we need to know who is running the country, we need to meet with them, we need to hear what they have to say. And then once we filter all of that by our own analysis, come to a conclusion whether we can trust them or not. At the end of the day, it's a matter of trust, willingness is a matter of trust.

Greg Campion: Got it, okay. Well, if we put all of this together, so we've talked about economic growth, and inflation, and geopolitical risks, all the big topics for emerging markets. Taking all of this into consideration, where are you seeing the most attractive value today?

Ricardo Adrogué: So still interest rates, global interest rates, and emerging market interest rates seem to be the most obvious and attractive opportunity in the market today, early 2023. Currencies, broadly speaking, but some selected currencies look fairly attractive in this environment, especially in environment where we are seeing the end of the tightening circle in the US, which we mentioned potentially the US dollar could weaken. We don't have a strong call in US dollar, but certainly it's unlikely that it will strengthen further from here. Most natural thing would be to weaken a little bit. And then within credit, we thought that the biggest attractiveness of credit was related to US treasuries. So the high quality, not US treasuries, but emerging market credit that was high quality, because in the face of recession or potential recession or clear slowdown, credit is potentially not very attractive. But if you hide in the best quality credit, those will certainly not default and they will benefit from US treasury rallies. So in 2022, emerging markets suffered big losses from return perspective. But when you decompose that or when you take it apart, you see that 80% of that was US treasury alone, and 20% was the weak credits really selling up dramatically, some single B is really blowing up in strength, both on corporates and sovereign. Now looking in 2023, the US treasury could rally, and that will be a big tailwind for credit. And that's something that we started to see already in early January. The surprising thing is the market seems to be very forward- looking and we're starting to see credit that we are not so sure they're going to make it that have been running in the early parts of January, so the market seems to be moving way ahead and faster than we had anticipated, even in our optimistic view in late 2022.

Greg Campion: Got it, got it. I remember when you wrote a piece back in 2014 or 2015, this might be dating us a little bit when you were very bullish on EM local currency debt, and it turned out to be a great call. So it's interesting for me, when you get more optimistic about markets, my ears perk up and I listen. Compared to that point, and not to make any predictions on returns or anything like that, but compared to that point, how positive are you feeling on emerging market assets generally as we head into this year? And is there sort of one or two indicators you would advise our listeners to sort of keep an eye on to tell how this is going to play out this year?

Ricardo Adrogué: So I would say, if I recall correctly, I'm structurally more constructive now than I was back then, so I think it has more legs, the attractiveness of the asset class today than back then, especially on the local side, but also on the currency side is hard to call because spreads are not as wide as they were when we put that piece back in 2008. I think it was late 2015, early 2016. And so the call on currency assets, US dollar assets in emerging markets is highly dependent on US treasuries for the better quality and very selective on the lower credit quality, sovereign and corporates for the local component, because flows have been going out of emerging market for such a long period of time, technicals are very attractive. And so the valuations are attractive, the US dollar potentially has peaked. The effect of the war, Russian war in Ukraine on economic activity in Europe hasn't been as dramatic. China is reviving, so there are some very strong fundamental reasons that this could take some time.

Greg Campion: Well, very encouraging to hear you positive on your markets again, and I hope that investors have gotten some value out of listening to this conversation, I certainly have. I appreciate you joining, and I really always appreciate your insights. So thanks, Ricardo.

Ricardo Adrogué: Thank you very much for having me.

Greg Campion: Thanks for listening to episode number one of season eight 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 and emerging markets, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. We publish a new episode every other week. And if you have specific feedback, you can email us at podcast @ barings. com. That's podcast @ B- A- R- I- N- G- S. com. Thanks again for listening and see you next time.


Ricardo Adrogue, Head of Global Sovereign Debt and Currencies discusses the Barings' team's increasingly positive view on the outlook for emerging markets debt.