Jenna Dagenhart:

Hello and welcome to this Asset TV Emerging Markets Masterclass. Our three panelists today will give us an overview of the current landscape, look at the role of emerging markets within a portfolio, and cover some of the key risks and opportunities in EM. Joining us now, it's an honor to introduce Chris Hays, EM external debt strategist at TCW. Damien Buchet, chief investment officer for Finisterre Capital with Principal Asset Management, and Jeffrey Buchbinder, chief equity strategist at LPL Financial.

Well everyone, thank you so much for joining us and setting the scene here. Damien, why should US investors hold EMD in their portfolios and what are the key attributes of an EMD allocation for them?

Damien Buchet:

Well, over the years I would say that the EMD has mostly been a key provider of income and diversification to global investors, including US ones. I mean, to be sure, income has really always been your best friend in its asset class. I mean, if you look back 20 years, roughly 100% of your average annual return is just made of income and that holds for both hard and local currency assets. So that's quite an interesting consideration here.

Now, when it comes to diversification, it's mostly about the diversification of a macro and default risk across your portfolio. I mean, you will never find that level of macro differentiation in any other asset class. So that comes from the many countries which we have to deal with, about 70 countries. But as well from the ability which we have to express ourselves across so many asset classes, whether sovereign debt, corporate debt, but also local bonds, rates, FX. So these are as many ways to reflect different views on a given country's situation which you have at your disposal. So that makes for a very creative asset class.

What I also like is the fact that your default experience when it comes to EM corporates in particular, is so much lower than similarly rated US high yields. So that owes to a specific arbitrage opportunity that you have in EMs, which is that a corporate can never be rated better than a sovereign, with a very few exceptions. So by and large, what you tend to get when you look at EM corporates are credits which may be exhibiting much better metrics than their rating would suggest, because by default they can't exceed the rating of their sovereign. So as a result, if you look at the stats, the default stats, by rating, you would find that over the past 40 years at every rating level, but especially so in high yield, EM, BB, B default experience, is way lower than comparable US credit. So that makes for a number of opportunities which are live in this asset class.

Now when you look at return X income though, income being your best friend, you could argue it's a bit more disappointing. So long for the long-term narrative that this is a trending asset class, which will eventually make you converge to developed market standards. That's not happening. So yes, we've seen a lot of progress on policymaking, on the sustainability of macro situations since the early 2000s, after the Asian, Russian, Argentinian crisis, but it's not really translated into a much stronger potential growth. So part of that is because we're still in a transition towards a new business model in EMs. The old model was heavily reliant on China, commodities, globalizations, all of which are now in retreat.

So that's probably the reason why over the past 10 years we haven't seen X income, a lot of price appreciation in EM debt. Now that doesn't mean it's going to remain [inaudible] forever. EMs are, in my opinion, in the midst of searching for a new business model. There are many opportunities which I'm sure Jeff could talk about as well as a equity specialist. But I'm quite hopeful about the integration of technology in production processes. Productivity gains are very easy to extract. So many opportunities, but it's mostly an income and diversification play to speak of when it comes to EM debt.

Jenna Dagenhart:

Jeff, turning to you, what are some of the benefits of allocating to emerging markets?

Jeffrey Buchbinder:

Yeah, thanks Jenna. The benefits are really similar on the equity side as in the fixed income side. You get the diversification, you give yourself a bigger pool to fish in, essentially, for opportunities. And certainly you can find economies that are zigging while others are zagging. Right now the US economy is on the way up and the Chinese economy may be on the way down a little bit. And so there's certainly different cycles there to play. We certainly have different monetary policy cycles going on right now, which actually makes Japan an interesting market to look at. But we had a rate cut in Brazil, we may get cuts out of Mexico. So Latin America looks interesting too in terms of a monetary policy cycle that's maybe in a better place right now than the US for the moment. And then you've got this nearshoring trend or the de-risking of supply chains that you can play outside of China in EM or certainly some developed markets.

Jenna Dagenhart:

Chris, turning to you, what stands out to you at the moment when you look back at the first half of 2023 and where we are today?

Christopher Hays:

Thanks, Jenna. So for us I think, and for really the entire global fixed income market, I think it's been the resilience of the US economy and how markets have reacted as that economic strength or that stronger than expected macro environment in the US has become more obvious in recent months. So if you start, you look at the first part of this year, you had a market that was pretty concerned about what the impact of the rapid pace of hikes in 2022 would be on the economy. And when Silicon Valley Bank collapsed in early March and we had this fallout within the regional banking system, I think the market really decided that that hard landing narrative was much more likely and you had this really strong outperformance of investment grade credits as investors pushed into businesses and countries that could better weather an economic downturn in a tighter credit environment.

And then what you've seen since then, as the economy or as these worst case fears related to Silicon Valley Bank, related to things like the debt ceiling debate, that blew by without a hiccup and related to this sphere that that 500 plus base points of hikes were really going to push the US economy into recession. As these worst case scenarios have failed to materialize, you've seen a real strong performance of high yield rated bonds in the last couple of months. And so year to date, we're looking at an investment grade market that's up about 2%, a high yield market that's up about 7%. And most of those gains on the high yield side have come in the last few months alone. And even deeper into the high yield [inaudible] distressed segment of the market, you're seeing CCCs in the emerging market space [inaudible] about 30% total returns on a year to day basis.

And again, a lot of that has come in recent months as fears about credit tightening and fears about recession have unwound. And in addition to that, you've had some positive outcomes on the political front in certain countries. You've had better than expected IMF decisions related to some of the countries that it's supporting in recent months. So there's been this tailwind that's pushing up the more distressed and higher yielding segment of the market in recent months in that. So the US economic resilience and then the high yield rally that we've seen since that became more obvious has been certainly a standout driver of performance this year.

Jenna Dagenhart:

And rewinding a little bit, Damien, 2022 was one of the worst years on record for emerging market debt. Thanks of course to a toxic mix of a strong US dollar, rising US yields, default events, and geopolitical risks. What's your assessment of the asset class today and going forward?

Damien Buchet:

Not surprisingly, a much better assessment. I mean, these days we continue and we've been a strong advocate of EMD since late 2022. I mean, first of all, we quickly saw that all those headwinds were not quite turning into tailwinds, but were fading. I mean, that in itself after the purge we've had in 2022, and that's really what you should love about this asset class, the fact that we should start with that, technically, it's perhaps the cleanest and most asymmetric of all global fixed income asset classes today. If you think about it, we've seen, looking at the EM mutual fund sample, something like 80 billion of outflows last year. That's four times what we saw during taper tantrum, three times what we saw in 2015.

So the starting point for this year was always going to be very, very clean from a technical standpoint. And that's what we like. And a lot of value has been created. Most of the risks have been exposed. We had ample opportunities to sift through the rubbles at the end of last year. We've seen many EM countries default. But interestingly against that, apart from those odd defaulters in the distressed frontier space, when it comes to incumbent EMs, fundamentals have held up relatively well. In terms of growth, in terms of fiscal balances. EM central banks above all have been totally on top of their jobs. I mean, they recognized inflation way earlier than DM central banks, and they acted much more resolutely at the very start of the inflation cycle than the Fed, the ECB, the Bank of Japan.

So for all of those reasons, a number of core EMs have actually proven to be much more stable than anyone could think in the worst US hiking cycle of the past 30 years. At the worst point when the dollar was rising by 20% against G10 by, I remember mid-September last year, on a year to date basis, EM FX was only losing 8%. So that tells you something about the resilience of this asset class in the face of the most toxic mix. So we really love it as the cheapest, most on their own, technically ultra clean asset class, among global fixed income where risks are already fully exposed, appreciated and priced.

Now, even if the global duration rally that many have predicted so far this year, which has remained arguably quite elusive, even if it doesn't happen immediately, you're still paid to wait for that rally. And that's also what we love. So all in, it's the most asymmetric asset class in global fixed income in our opinion. I.E. way more upside than downside. And you'll be hard-pressed to find a better arbitrage opportunity elsewhere.

Jenna Dagenhart:

And Chris, how would you characterize the current environment for investors in EM fixed income?

Christopher Hays:

Yeah, we agree. This is certainly a really exciting time for EM active fixed income managers, and really as exciting of a time as any sensible financial crisis, I think, for a couple of reasons. So first is valuations. 2022 was obviously difficult year for EM fixed income as it was for all global fixed income. But as markets repriced, the higher inflationary, higher interest rate environment, it's left yields at historically attractive levels. So in our world, we're looking at 90 to 100th percentile yields over the last decade in our market. We have an EM sovereign market that's yielding about 8.5%. That puts it around the 93rd or 94th percentile in the last decade. Within the market, investment grade yields are basically at the 100th percentile. We're looking at the highest yields these segments of the market have given investors or paid investors since really the Global Financial Crisis. And on the high yield side, similar. Less exciting on an absolute level. We're closer to the 90th percentile rather than 99th, 100th, but we're still looking at 12% yields across a good portion of the EM high yield universe, which makes a lot of sense.

So one is valuations and two is also... We agree, fundamentals are relatively strong on both the sovereign and the corporate side. So the sovereign story is relatively clear. You have this historic inflation cycle in the US. But in the emerging markets, this isn't necessarily anything out of the ordinary relative to the last couple of decades. And so we had EM central banks hiking over a year before the Fed began its hiking cycle. And what you're seeing as a result of that is inflation has come down more rapidly in some of these countries. And some of these countries are already beginning their cutting cycles. And we think that will lead to stronger growth in some of these economies. And by the middle of next year, we think the large portion of our emerging markets sovereign universe will be in a better place economically than they were today. And also on a relative basis, would we expect that spread, that growth spread between emerging market sovereign growth and US growth or developed market growth to continue widening in the years ahead. On the corporate side, similar story.

So we're sitting at some of the best leverage and interest coverage ratios in at least the past decade. Potentially in the history of the corporate market. You have a high yield market in EM with net leverage, a turn and a half below that of the US high yield market. And actually a half a turn below the average net leverage of the US investment grade corporate market. So you have really resilient and strong fundamentals on both the sovereign and corporate side. And even if we think that fundamentals are peaking right now on the corporate side, we think interest coverage ratios will probably decline from here, as some of the issuers that have held off issuing in the last couple of years have to refinance at higher yields. We like the starting point a lot and we think that it is especially strong fundamental starting point that should help these issuers weather the storm as global growth continues to slow in the year ahead.

Jenna Dagenhart:

What about on the equity side, Jeff, and the cheap valuations there? Are valuations enough of a reason to be in EM?

Jeffrey Buchbinder:

Well, actually we don't think so. The LPL Research house view is to be underweight EM, although that does support modest exposure. So a few points of active equity EM we think makes sense, but we are underweight. We would say it's a couple key reasons why. I mean, the earnings haven't really come through, at least at the index level. Of course there are opportunities at the stock level or the country level. But at the index level, which is of course dominated by China, we've seen earnings really stagnate. In fact, the MSCI EM index is supposed to generate a 10% earnings decline this year based on consensus. We'll see if we get a rebound next year. But the track record for EM of generating the earnings that analysts expect, at least over the last few years has been spotty at best.

So it looks cheap, 11 and 12 times earnings, great opportunities in individual names,. Love the idea of being active in EM on the equity side, but at the index level, we're not as interested. Because you've got a little bit of a value trap potential there with those earnings not coming through.

And then because we're global asset allocators, we're always going to look at opportunities in other countries. And so if you look at a country like Japan, for example, which is similarly cheap relative to its history, you're certainly getting better corporate governance there than you're going to get in China, for example. And you've got more buybacks, more dividends coming out of that country. They're in a little bit of a better place maybe in terms of monetary policy than some other countries. So when you compare a market like Japan or even some areas of Europe, valuations are also really, really cheap.

So we just have a hard time justifying an overweight to EM. So right now we're overweight international equities. The house view for LPL Research, the tactical asset allocation committee likes equities overall as a neutral with a little bit of a tilt towards developed international with that EM underweight. Although I'll say, EM equities could certainly generate positive returns, especially with the monetary policy cycle there looking better, the potential for a weak dollar. We are not necessarily EM bears, we're just saying go active and maybe you've got at least in the second half of the year, better opportunities in the developed markets.

Jenna Dagenhart:

And Damien, how has the EMD asset class evolved in the past few years? You mentioned some big changes and what does it imply when it comes to picking the right investment approach?

Damien Buchet:

Yeah. I mean, one of the basis of our approach is to argue that indices have lost their relevances over the years. We don't like to think alongside asset class lines. The idea that you should treat or approach from an investment standpoint, a sovereign credit differently from a corporate one. I mean, the only difference between the two being the way you analyze them, but at the end of the day, they all behave the same. They behave like credit. And you could argue the same for local currency bonds which have the reputation to be a volatile place due to excessive effects of volatility. In practice, when you look at each name in turn, you would be able to find some very resilient buy and hold opportunities in the local currency space with low volatility currencies.

So the boundaries of indices have become relatively artificial in our mind, especially when you consider the massive changes of fortunes of some former index heavyweights. I mean, let's not talk about the demise of China and China credit, which used to be a huge part of the corporate credit universe, has being wiped out through the demise of the property sector.

We've had a almost permanent recomposition of the investment universe, the advent of investment grade countries from the Middle East in the past year and a half... Sorry, in the past five years. So we now have 15% of A, AA rated sovereigns. Mostly oil producers from the Middle East. And at the same time, we had the emergence of a number of frontier markets. Not to forget the disappearance of Russia and Turkey or other index heavy weights from the landscape. So that's made for a huge recomposition.

So our take on that is that the best way to extract value and to deliver the best that this asset class has to offer is to think along different lines. No longer along asset class lines, but rather re-profiling your investment universe in terms of income assets, assets sensitive to the beta, which you can use to magnify an uptrend. Or alpha specific assets, assets which are less correlated, which are the opposite of beta ones. Special situations. And so that's how we like to think. More in terms of the right mix between alpha, beta, income and cash at different points in the cycle. Rather than asset class. So that's the essence of our more total return approach, which is structured but relatively opportunistic and it works best this way, we believe.

Jenna Dagenhart:

And Chris, what would you say are some of their key risks and opportunities right now facing EM fixed income markets?

Christopher Hays:

So I think the primary risks in our view are related to US interest rates, related to Chinese growth. And then on the emerging market side, specifically some upcoming presidential elections. So first on US interest rates, the risk is clearly that the interest rates go higher. That inflation remains sticky or even moves higher, which forces the Fed to push the terminal rate higher than the market is currently expecting. And so while this is certainly not our base case, it's definitely a risk that we're monitoring. And the real risk here in our view is not just the capital losses that bonds will sustain as interest rates move higher, but it's also, has really big implications for credit availability. So what we've seen in the last year or so, last year or two really, is that issuance in emerging markets is down significantly. And that's because the higher quality issuers don't want to come and borrow at higher costs and the lower quality issuers can't because they don't necessarily have market access.

And so the longer that plays out, the longer that this market remains closed, the more risks we see in the lower end of the credit spectrum on the high yield side. Related to China, there is a very clear restructuring of the private sector of the economy happening right now. And the risk is that they continue to lose confidence. Confidence in the property market amongst their consumer base, which we're already seeing signs of. And confidence from the investor base. And so on the Chinese side again, implications for significantly weaker growth than the market is expecting. We came into this year with a lot of optimism as Chinese leaders unwound the zero-COVID policy at the end of last year after the party congress. And mostly this year has been a story of the market being increasingly disappointed with the stimulus measures and the support to the property and private sector of the economy that the Chinese government has delivered.

So as growth expectations have moved from five and a half to five, and now are being repriced from five to four and a half, we think the real risk is that we're talking multiple percentage points lower than that. And that's going to be the risk to, again, lower quality issuers and lower quality countries. Also will have important implications for global growth and especially the [inaudible] Asian growth in that market. One thing I would say, or one thing we're thinking with respect to this underwhelming Chinese growth this year is that in this current dynamic, in this current market environment where the Fed is uneasy about inflation still and wants to remain vigilant until there are clear signs that inflation comes down to their target around two, it's not necessarily the worst thing in the world for the global market environment for Chinese growth to be underwhelming. Because if you think of what the flip side of that would be, booming Chinese right now, then try to imagine where the terminal rate in the US is and try to imagine how much further to go that the Fed has in its hiking cycle.

So we're comfortable with underwhelming Chinese growth. We're a little bit more worried about a significant downturn in Chinese growth. And again, not our base case, but something we're monitoring. And then finally, there are a number of presidential elections this fall in countries like Ecuador and in Argentina and even Pakistan. And what we know in emerging markets historically is that presidential elections can really fuel a change of narrative and a change in the economic circumstances of the country. I mean, take Nigeria earlier this year. President Buhari came in, and in his inauguration speech, announced essentially to reform [inaudible] FX and subsidy reforms that the market was looking for. And since then we've seen about a 20% rally in Nigerian debt, Nigerian sovereign debt. And so upcoming presidential elections will certainly have a big impact on the sort of idiosyncratic stories of a number of countries in our market.

Jenna Dagenhart:

Jeff, what about some of the headwinds and tailwinds for EM equities?

Jeffrey Buchbinder:

Yeah. Well, Chris alluded to the big one, which is China growth story. As certainly China not exporting inflation is a good story, but the weaker growth has certainly weighed on global exporters to some extent. It's removing an opportunity for some of the China tied European exporters, the China tied, certainly Latin American exporters. With the big natural resources exposure there. And then of course exports out of the US. So China is a risk. At this point a lot of these risks we think are widely known and maybe they're priced in with those attractive valuations that we're seeing. A lot of 10 times, 11 times earnings multiples on some of these EM names on the equity side do look pretty interesting, but who knows? We'll see if the China economy takes another leg down from here. But no doubt the geopolitical tensions there aren't going away anytime soon.

Certainly something that we all have to keep an eye on. And then the other risk I mentioned, I mean the dollar's a wild card, it's very hard to predict. But the earnings risk, right? We focus more on the index level, more the asset class level at LPL. But again, I mentioned the risks that the earnings don't come through. I think EM earnings have basically fallen short of expectations for I think 9 of the last 10 years. Had a great year in 2017. But it's just if you look at history, you typically are going to get closer to earnings expectations in the US or potentially even in Europe and Japan. So we want to be careful to make sure the earnings come through. One of the ways we mitigate risk is with technical analysis. So to get more excited about EM broadly, we'd really like to see some momentum in those markets. And we just aren't seeing it. We're seeing relative strength weaken relative to developed markets, breaking down below moving averages and things of that nature.

Jenna Dagenhart:

Damien, rounding us out here, what kind of key risks and opportunities do you see in the asset class over the coming year or two?

Damien Buchet:

Right. I may differ slightly from Chris and Jeff on the relevance of China because like many others we had high hopes on the Chinese rebound post COVID when the leadership chose to stop shooting themselves in the foot at the back end of last year. Actually, in pure macro terms, the accrued benefits we were all expecting on commodity producers or neighboring Asian countries through a resumption of massive tourism flows have not really materialized. There are many reasons for that. There have been in the commodity space many other dynamics which kind of explain why despite Chinese recovery, prices have not jumped through the roof. But conversely, the Chinese slowdown doesn't seem to have that much of an impact on those countries, whether... Commodity producers, after all, oil has remained in this Goldilocks range of $75 to $85, which is neither too hot for consumers or importers, and not too cold for producers.

So by and large, I would kind of tune down the Chinese risks other than the classic, which I don't believe a second, at least in the next couple of years, China attacking Taiwan or let's just think about... Let's leave aside Putin pressing the red button or even a resurgence in global inflation, which would really counter totally my positive narrative on EMD. I'm not a believer in that. That said, what I keep on the back of my mind these days is the risk, more of a perception risk, but the risk of these weather patterns igniting some soft commodity inflation again. Which would be a curse for many emerging countries. Closer to us, I'm more concerned by the fact that especially in local markets, we've had a very nice year so far. I mean, the local carry trade has been the leader in performance in EM debt.

We've had very high income, a very high income stream, steady to appreciating FX trends. Many emerging markets now have a kind of rich man problem when it comes to inflation. They've been so successful in taming inflation that they're now considering cuts. Way before the Fed does. And that should warrant some caution on the side of policymakers. We've seen that in the past three weeks in the case of Chile. Cutting a 100 basis points and sending the currency 6% to 8% down. So that's something that they should be cautious about. Not rushing in cutting rates. Preserving the risk premier or essentially adjusting the pace of rate cuts to their policy credibility, whether fiscal or monetary. So that's really what I'm keeping in mind at the moment in terms of risk on consensus positions. Now, you ask about opportunities. Despite that I still overall love local currency bonds from Mexico, Brazil, Colombia, Peru, Indonesia, mostly for their high yields. But also for the fact that I still believe, as Jeff said, we don't need the dollar to weaken much.

We just need to think that the dollar will not appreciate massively to be happy. I would also mention Eastern European local bonds. Which are lower yielding than Latin ones, but if you own them against Euro, that makes for a fantastic carry trade with very low volatility. In hard currencies I would still highlight Salvador and Tunisia among the performing stories that people dismissed quite a bit last year and which have proven to... They've muddled through. You don't know how long they can muddle through. Perhaps the next one year, two years. But so far, so good for now. And we see a number of defaulted or restructuring stories like Ghana, Zambia, Ukraine,.but that's very selective. Places like Pakistan and Sri Lanka for example, we wouldn't put a foot at the moment.

And then for corporates, it remains a credit pickers market. We've liked a lot so far this year, all those Eastern European bank papers, whose issue was mandated by changing European regulations. These MREL papers denominated in euros most of the time. So that makes for nice 7% to 8% yields in Euro terms. For very short dated bonds. And still like, Macau gaming, Israeli oil and banks. So there are a number of spots, but yeah, I agree, the second half may be a bit more discriminating than the first half in that respect.

Jenna Dagenhart:

And you've all mentioned China and there've been a lot of headlines related to China lately. So let's spend a little bit more time there. Chris, could you elaborate on the impact China has had on EM fixed income markets recently and what's ahead?

Christopher Hays:

So when we think of China, we really think of the post COVID era as a line in the sand marking what appears to be a paradigm shift with respect to how China wants to manage its domestic economy and how it wants to manage its relationship with the outside world. And so starting with this domestic economy, in late 2020 you had the implementation of the three red lines, which was a measure China implemented to try to restrict credit to the property sector. And what you've seen since is more than 50% of that sector has defaulted. And that number is rising. We're currently dealing with an issuer that was an investment grade rated issuer just a year ago. Bonds are now trading at about 7 cents on the dollar. And [inaudible] this point. And so what's going on here is essentially we think China is shifting its focus from growth at any cost to the quality of growth.

And the way it thinks about quality of growth is growth that it believes sets it up for the future. And that's a future with an increasingly antagonistic relationship with the US and the West. And that's a future that China believes no longer can rely on credit fuel to growth. And so what we're seeing is a shift from property, a shift from the tech monopolies that the Chinese government feels are crowding out small businesses and hurting the lower income segment of society, into the future tech areas of the world. So green energy, AI, robotics, areas that it feels it will need to... Areas of the economy it feels it needs to support to account for what will be an increasingly divided relationship with the US and the West in terms of their ability to access various segments of their supply chain. Semiconductors in particular are a big risk to the Chinese government and really to global governments.

So what China is doing right now is trying to position itself for the next decade. And the risk is that, or the risk to markets is that as it thinks longer term about growth, that it's sacrificing shorter term growth. And that really has been the case for a couple of years now. So when we think about China, it's one, we're not largely invested in the Chinese market right now. Actually we might have zero exposure in the Chinese market right now. But obviously China as large as it is, affects the entire global emerging market space. So we think there are changes. We think that these changes will be gradual, but they've certainly been felt in a pretty significant way so far.

Jenna Dagenhart:

Damien, what about you? How would you assess China's relevance for EMD investors these days compared to the past 20 years?

Damien Buchet:

Well, if we speak about fundamentals as we've discussed before, to me the main transmissions channel on the rest of EM remains on commodity producers and neighboring Asian economies through trade and investment channels. As we discussed before, the old EM business model was heavily reliant on China, but far less now. I mean, we've seen that at play this year. Both through the early recovery and now through the disappointment. It's not really affecting the rest of EM as much as we thought anymore. You could even argue that a number of countries have actually been benefiting from these Chinese misfortunes through the relocation of investments away from China towards Mexico. If Brazil gets their act together on this fiscal simplification reform, tax reform, I mean, that could potentially put Brazil in a good spot as well to secure... I mean, as a new investment destination in this relocation move.

So that's really about fundamentals. I mean, it's still highly relevant from a global macro standpoint. So I love being able to play China through the currency, the rate side, as a key macro theme. But if we look clearly at the direct relevance of China in EM debt, and I believe that's a sharp contrast to Jeff's universe on the equity side. But if you think about it, after the demise of the property sector, the Chinese credit space have pretty much been wiped out. So there isn't much to speak of in terms of Chinese credits anymore.

At the index level, we are talking about mostly investment grade, quasi sovereigns, talking of the investible ones. And when it goes to local currency bonds, whether on the rate side or the FX side, even though China is officially 10% of the GBI-EM index, it's always been a very low volatility contributor to that index. In other words, whether you are overweight or underweight, China never makes or break your performance for the year. So I would dismiss a lot of the common narrative that China is so relevant to EM, that we're all hooked to the fortunes of China. I quite disagree with that both fundamentally, but also from a more technical standpoint when you look at the composition of our universe today.

Jenna Dagenhart:

And circling back to the commodities conversation, Jeff, what are commodity prices telling us about China's growth outlook?

Jeffrey Buchbinder:

You can read the headlines and see the trajectory of Chinese growth, but certainly commodities are telling the same story that we're reading about every day, that China's slowing. I think copper is down about 3% year to date. More broadly, the industrial metals. Bloomberg Industrial Metals index I think is down 16% year to date. So that's one way that slower growth in China is showing up. Damien's completely right on the stark differences between the equity and fixed income benchmarks for EM. I think China is close to 40% of the EM equity index. So we have to pay real close attention to it. For folks who use exchange traded products, you could look at EM ex-China, we think that's an interesting way. Or just generally EM debt or EM equity managers that just have very little Chinese exposure. That to us makes a ton of sense. I'm an equity strategist of course, but on the fixed income side, we do like EM debt more than we like EM equity.

And that's I think part of the reason. You have much less exposure to China. You get the attractive yields. Maybe you get a kicker from a little bit of a weaker dollar and certainly Latin America and some other Asian countries could take advantage of the global supply chain de-risking from China. So we like those stories. Just overall we don't want to take too much credit risk. So in a fixed income portfolio where an investor might have core bonds in a 60/40, if you've got 40% core bonds, maybe just add some additional credit risk, either EM debt or another credit area or credit plus, maybe some people would call it. And EM debt can fit nicely in that bucket. We actually like preferreds as well in this environment where banks have had their troubles. More bank headlines lately about more downgrades. And we think that preferred securities offer pretty attractive valuations here. So that's another idea in addition to EM debt as a place to look for fixed income opportunities to get a little bit of extra yield and maybe some capital appreciation on top of that.

Jenna Dagenhart:

And Chris, how are you thinking about commodities here and how do you position for that view?

Christopher Hays:

On a shorter term basis commodities tend to be driven more by growth expectations. And so what we've seen as risk assets have rallied, as the soft landing narrative has improved, we've actually noticed that commodities have underperformed equities and higher yielding credit relative to their normal relationship with those. So while short-term fluctuations in commodity markets are mostly demand driven, our longer term thesis is that there will be very supportive supply environment mostly driven by underinvestment in bulk metals and oil. Which has been the case for the past decade or so, but also we expect to be the case as we move forward. So when we're thinking about commodities and positioning for a broadly higher commodity environment over the next 5, 10 years, the EM asset class really stands out as an exceptionally attractive place to get that exposure. So about half of our market on the sovereign side, it's comprised of exporters. The other half obviously importers.

And so when we think about positioning with a bullish commodity view or a bearish commodity view, what we're essentially doing is we're looking at valuations in the Middle Eastern investment grade exporter space, and how those look relative to maybe Central and Eastern Europe importers. And then on the high yield side, we have markets like Angola and Nigeria, which are our big export of oil and have underperformed in the last few months. Still with lingering concerns from the SVB crisis earlier this year and the hard landing fears earlier this year. Those have underperformed. So we may take a bigger allocation or move a chunk of our portfolio into these exporters on the high yield side to take advantage of what we expect to be a supportive commodity environment in the years ahead. But we really do have that opportunity set across the market. And then you add in the corporate space, oil and gas and metals and mining producers across EM.

And there are pockets of the Brazilian oil and gas market, the Columbian oil and gas market that we find attractive. And some of these are a little bit less liquid on the corporate side, but if we can hold those for an extended period of time and wait out the liquidity driven underperformance or liquidity driven, period of time where we can't necessarily reduce or add exposure to these categories, you get some really juicy aggressive yields in certain segments of the markets. So whenever our commodity view is, there are a lot of opportunities in our world to take advantage of it, and I think there tends to be a stigma about emerging markets that it is entirely commodity sensitive. Where the entire market is exposed to commodities. And that's clearly not the case. And we can see that as performance plays out with some of the importers outperforming as oil prices, commodity prices decline and the reverse happening, as oil and commodity prices rally.

Jenna Dagenhart:

Damian, how are you thinking about FX?

Damien Buchet:

Well, for me, FX has always... I've always seen FX, EM FX as the equity of fixed income, right? So essentially unlimited upside, unlimited downside, massive volatility, which is why we don't like EM local currency for a strategic allocation. Because if you're in the business of trying to achieve the best possible risk return profile, the best possible Sharpe ratio, too much EM FX exposure will destroy that Sharpe ratio over time. But it's also a highly liquid and most rewarding asset class when you have macro views. Your views, your changing views get reflected much quicker on FX. And it's a highly tradable, highly liquid asset class with lots of derivatives. So a great space to express macro views.

So that's how we look at it in the portfolio. A lot of our momentum plays tend to be done by FX, right? So when you really want to quickly capture an uptrend, then FX would be the way to go. Now, when I think about what we like on FX these days, I mean, if I reflect on this year, I mean, it's been touted as a... As I said, the local part of the universe has been a massive outperformer this year, which is quite rare because if you look at currencies, they've tended to depreciate over the past 15 years by about 50% versus the dollar. But EM FX was very resilient versus the dollar compared to DM FX last year. And we've been tested on that narrative again several times this year. In February, in April, in June. To me these days, largely thanks to the credibility of EM central banks, which I said were instrumental in rebuilding this risk premium ex-ante, before the inflation issue became global.

That's bought us a lot of protection. That's bought us a lot of yield. And that's made the FX carry trade so much more attractive. As I said, I remain quite positive on the ability of EM FX to perform, but perhaps a bit more selectively than in the first half. I didn't expect so much appreciation in the first half. We're still [inaudible] by very high income there. But the heydays of easy appreciation are probably behind us for this year. So I would expect more of a steadier FX behavior versus the dollar for the rest of the year rather than a broadly appreciating EM FX landscape.

Jenna Dagenhart:

Jeff, how does the US dollar play into your views on EM?

Jeffrey Buchbinder:

Yeah. I mean, it's a potential positive here because certainly we know the Fed is still potentially going to hike further and we've already started some rate cutting campaigns in some EM countries. So you got to think about that certainly. So maybe the very short term, the dollar is a little bit of a drag. But we actually think it's going to be a tailwind over the next couple of years. It's been frustrating maybe for some people who have looked at the US, the twin deficits, the budget deficit and the current account deficit, which is trade. And when you're running big deficits, you should have a weaker currency at least at some point in the next year or two. But we just haven't really seen that. The dollar is still the safe haven for the globe. And so you get these periodic waves of buying where it really doesn't matter what our trade situation looks like.

So we think the dollar's going lower maybe over the next several years. That's a tailwind for EM equities. But certainly in the near term, we're not buyers of EM equities on a bearish dollar view, we would be more interested in looking for opportunities maybe in Europe. The ECB is going to hike longer than the Fed. That potentially creates a situation where you have a little bit of dollar weakness against the Euro and that can help US investors in Europe. I mean, the other side of that though is that European exporters can be hurt by a strong Euro.

And so that effect is more of a lag, right? So really what matters to investors thinking about the next quarter or two is the currency translation of foreign returns back in US dollars. So on that score, we think there's interesting opportunities maybe in Europe, maybe even Japan, just based on currency. But the currency piece is not quite enough for us to prefer EM equities over US equity. So we'd still rank them developed international first, US second, EM third on the equity side.

Jenna Dagenhart:

Chris, how were you thinking about quality exposure and the portfolio and positioning between investment grade and high yield [inaudible] markets?

Christopher Hays:

Most EM debt funds tend to not have any sort of a rating criteria. So you're investing across the rating spectrum. Both IG and high yield, which is a bit different than the way the US corporate market works. Which tend to be divided with a clear line between investment grade high yield. So we have the ability to invest across the rating spectrum. In our markets high yield and IG each represent about 50% of the market. We like to separate them out and think of them as distinct units within the portfolio. And we think that makes sense. If you look at the performance of EM investment grade bonds, they're more highly correlated to US investment grade bonds than they are to emerging market high yield bonds. And the same goes for emerging market high yield bonds, which are more correlated to US high yield corporates than they are to emerging market investment grade bonds.

And so we do think of them as being driven by different macro factors and they tend to perform differently in certain macro environments. Currently we think investment grade is struggling from a relatively tight spread. And that's not unique to EM investment grade, that's the case in the US investment grade corporate market as well. When we think about performance from here in the US [inaudible] market investment grade space, we think a lot of that total return. The potential total return in the year ahead is going to come from treasury yields coming down if that does happen. So we think there's a little bit more of an attractive valuation dynamic in the high yield space where spreads still have a cushion and that will help the high yield market in the event that interest rates, US interest rates rise. Those higher yields and higher spreads can tighten into that rising US interest rate environment.

And you also have a higher [inaudible] bond to offset some of the capital losses as yields reprice and total returns move a little bit weaker. But we're not as extended in high yield as we would be in a more bullish environment. High yield has come a long way in the last few months, in total return terms, and spreads [inaudible] a decent amount. So we think that performance in the high yield space, while we do expect it to outperform investment grade into year end, we think that the return profile will be a lot more differentiated. So what we've seen in the last few months is basically a rising tide lift all boats. You've seen maybe 90% of CCC rated debt up 30% in three months with very little variation. A couple of outliers within that sample size. And from here, while we still see certain pockets of opportunity in that space, we think that market is going to be a lot more discerning about which of those markets rally and where resources are allocated at these levels right now.

So heading into year end, we're positioned with a marginal overweight in high yield, a marginal underweight investment grade. And then within the investment grade space, we're a bit long duration and what we think about that exposure is essentially, that will help cushion some of the underperformance in the high yield [inaudible], in the event we have a sooner than expected downturn or in the event that come this fall, the market's focus has shifted away from soft landing and is moving back to the other end of the spectrum towards maybe a less optimistic growth environment than markets are currently pricing in.

Jenna Dagenhart:

Damien, how are you positioning moving forward?

Damien Buchet:

Well, I mean, we remain resolutely on the bullish side. The key question is how... It's not about the level of risk, it's about the type of risk you want to take. So yeah, we still like, in that order, we still like duration first. You could argue that, and since I'm a strong believer in continuing disinflation in the US and in the ability... We were early on and fairly lonely on that kind of soft landing call earlier this year. It seems the market has corralled around this view now, of some kind of a Goldilocks view. It doesn't mean we won't see a slowdown in the US economy later in the year. We're still expecting that. That should be totally normal and expected. It would be the most expected slow down, but it won't be a massive recession. So we think that the way the pain will translate in the US system is more through partly what we saw with SVB and First Republic.

I mean, there are some corners of the system which are highly sensitive to refinancing risk, highly sensitive to leverage conditions. So I'm not excluding to see other places popping up, other bubbles, small bubbles in the financial system popping up, but nothing of the kind to make us move into a total tailspin. So I'm still quite constructive. I'm still expecting this duration rally, which is very... She's taking its time to come. And that's probably what I'm waiting to be a lot more forceful on my EMD allocation. So these days I'm still relying on carry as the key driver of returns these days. Starting with, high carry, local bonds. I don't dislike US treasury duration. So back to those yield levels above 4.0, 4.2 on 10 year yields. I totally buy in what's priced in the US curve. I don't believe the Fed needs to deliver more than say at worst one hike from here.

And the situation is a little bit more... So I like duration first. Then currencies as a neutral force. As long as currencies don't depreciate, I'm quite happy. That allows me to earn that high carry on the local side. And when it comes to hard currency, I mean I'm siding totally with what Chris was saying. I mean, it's hard to be totally bullish on investment grade even though adjusted for the risk you take, it's probably around fair value. Especially in the light of what he said about commodity producers being on the right side of the fence, especially Middle Eastern oil producers.

But it's become a highly segmented market. So value remains on the side of higher yielding names. Yes, some of those distressed names have rallied a long way. Now, going back on what we said about the crux of the issue for frontier market, which is lack of access to refinancing. Perhaps things could change if duration was coming back in vogue. So I would wait for that duration rally to materialize on the back of US disinflation to assume that EM hard currency credit spreads could trade at tighter levels.

For now, we're relatively neutral on credit risk, spread risk. Still looking for alpha opportunities more than anything else. So I'm totally siding with Chris on the more discriminating approach in the second half. That's the name of the game. Doesn't mean we are turning negative on EM. It remains the best place to be and the most asymmetric of all fixed income asset classes for the remainder of 2023.

Jenna Dagenhart:

And Jeff, what's your technical outlook for EM? And any final thoughts that you'd like to leave with our viewers today?

Jeffrey Buchbinder:

Yeah, well I first want to tack onto the bond discussion. Go a little bit outside my lane for a second and just share that historically, at least in the US, rates have fallen after the Fed stops hiking. Right? So we actually think you're going to get a rate tailwind here for bonds over the next 6 to 12 months. You'll have the combination of the Fed stopping and inflation continuing, we think, continuing to come down. Which makes fixed income attractive. I'd say we like fixed income as much as we have broadly in several years. So I want to just throw that out first of all. So our 10 year yield forecast for year end is a range of 3.25 to 3.75. You clip these coupons, not just US treasuries, but EM. You clip these coupons and then you get a little bit of a rate tailwind.

You've got a nice formula for a nice return on the fixed income side. And the hurdle for US equities to beat that is pretty high when you're starting from the high valuations we have in the US. So that's one point. The next point on just EM technically. So we do follow the charts to make sure that we either confirm or reject our views of the fundamentals. And so our fundamental view of EM, on the equity side again, has been more mixed, but the technicals are confirming that. And telling us that it's just too early to make a bet on EM equity. So we're not doing that right now, at least not in size. We're again, slightly underweight, have a few points for diversification in your global asset allocation. That's totally fine. Valuations do help you over the long-term. They might not help you over the next year or two, but long-term you tend to see the markets that are more cheaply valued generate the best return.

Right now, the technical picture for China and EM broadly is quite negative in absolute terms. It's not an attractive economy right now. You saw that in the latest round of Chinese economic data. And you can see it in the commodity prices. But that's an opportunity for other markets. The reshoring theme and companies moving out of China and into other countries providing a great opportunity. I mean, some of the initial countries that got all the attention were Vietnam and maybe Malaysia, Mexico. But I think that's even expanding to other opportunities.

So love, again, the idea of being active in EM equities and finding those opportunities. Areas that are benefiting from the global de-risking outside of China. But if you just look at the EM index broadly, you've got deteriorating relative strength. However, the relative strength trend is near the 2022 lows relative to the S&P 500.

So there's a potential for a bounce there off of support. So maybe there's an EM index trade in there somewhere, or even an EM ex China index trade in there coming soon because the market is oversold. It's so cheap and there aren't a whole lot of China equity fans out there right now. So that's certainly something we're watching. But we're in a downtrend that we've been in for the past couple of years, and on a relative strength basis versus the US, the relative strength's broken down below its moving averages, and it's telling us that it's not quite time to add exposure there just yet.

Jenna Dagenhart:

Well, everyone, thank you so much for joining us today.

Damien Buchet:

Thank you.

Jeffrey Buchbinder:

[inaudible] Jenna.

Christopher Hays:

Thank you.

Jenna Dagenhart:

We really appreciate everyone watching this Emerging Markets Masterclass today. Once again, I was joined by Chris Hays, EM external debt strategist at TCW, Damien Buchet, chief investment officer for Finisterre Capital with Principal Asset Management, and Jeff Buchbinder, chief equity strategist at LPL Financial. And I'm Jenna Dagenhart with Asset TV.