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Emerging Markets – The End of Free Money?

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By Warren Hyland, Portfolio Manager, Muzinich & Co.

Emerging markets holding up despite a shaky start

Despite a shaky start to the year for risk assets, emerging markets have held up relatively well and we believe offer encouraging investment opportunities which are backed by economic recovery.

January was a difficult month for capital markets; government yields rose, and curves flattened, driven by a hawkish US Federal Reserve. Credit spreads moved wider, and equities fell, while emerging markets outperformed their developed market counterparts.

Sectors that performed well were commodities and industrial metals, with aluminium outperforming and energy products rising into the double digits as supply chain disruptions and surging demand drove prices higher.

However, the first month of the year was not a standard risk off market because it was unusual to see government yields move higher, emerging markets outperform developed markets and commodity prices so robust. 

End of Free Money?

In our view, capital markets are facing, “The End of Free Money” and, at the margin, a pickup in geopolitical uncertainty and maybe reduced liquidity as Asia moved into the Chinese New Year holiday season.

As a bond investor, this means staying out of low coupon bonds. It also means that, as spreads widen, high yield is a buy. Fundamentals will likely remain strong and a preference for higher yields could bring buyers back.

But will EM suffer from the end of free money? Today, in aggregate emerging market sovereigns are in current accounts surplus, driven by high commodity prices and strong trade.

Economic growth is above its long-term trend with fiscal deficits falling in comparison to the last two years. Foreign exchange reserves are ample, and EM central banks have normalised monetary policy ahead of the US. A good example is the net supply of EM corporate bonds in 2021, -US$25bn – the universe shrunk by US$25bn and our estimate for this year is that the universe could shrink by up to -US$40bn.

This may be partially due to the Middle East & Africa reverting to a previous policy of paying royalties from their energy dividends and away from bond issuance. A heavy election calendar in Latin America in the second half of the year, and A deleveraging trend in Asia should also help reduce supply. In our opinion, this time around the free money has gone into low-coupon products such as investment grade, the technology/digital sector and special purpose vehicles.

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