Elizabeth Moran sat down with emerging market expert Damien Buchet CIO at Finisterre Capital and previously Head of EM Fixed Income at AXA Investment Managers.
The key points:
- Emerging markets (EM) debt investors are not overly concerned about the impact of Trump’s tariffs on their portfolios, as the most exposed countries like Mexico have managed the situation well so far.
- China has also responded strategically to the tariffs, focusing on preserving its trade links with the rest of the world rather than just retaliating against the U.S.
- The most exposed EM countries are likely some Southeast Asian nations that have served as rerouting bases for Chinese exports, but even their impact is expected to be manageable.
- Overall, EM debt has shown resilience in the face of rising U.S. yields and other macro shocks, and the asset class is currently under-owned by global investors, suggesting potential for future inflows and returns.
- Returns for 2025 are expected to be in the high single to low double digits, driven by carry and the potential for a reduction in Trump-related noise impacting valuations.
EM – I’d like to talk about Trump and tariffs given everything that’s happening in markets. He’s not looking like he’s going to back down. How are emerging markets countries, in particular, going to cope with changes in prices and fluctuations in US dollars?
DB – Well, first of all, the tariffs are taking different shapes. You have these universal tariffs, like what is imposed on steel and other industrial metals, which Australia was trying to get an exemption from, but apparently in his mind, this is one size fits all for this one. You have tariffs which are seen as a true way to rebalance global trade imbalances between the US and the rest of the world, as well as a way to finance the budget. So be it, also on certain commodities.
Then you have tariffs as a threat to obtain other things. That’s essentially what is held against Mexico and Canada in particular. He’s tried that successfully with Colombia, when Colombia first started to refuse to take back some flights with migrants abroad. That’s another dimension of tariffs. Then you have tariffs as a strategy containment tool, which essentially is what is meant to be for China, and perhaps at some point, for the EU, especially the EU car industry.
There are different ways you need to think about tariffs, but at the end of the day, what strikes us is that from an EM debt standpoint, the impacts are quite different between EM debt investors and EM equity investors. From an EM debt standpoint, tariffs actually don’t matter much. Most of the countries which represent a true performance potential for us are clearly not in the first line of fire. Clearly, the most important for us is Mexico, but at least you can say that Mexico has played their cards very well so far.
Of course, you can’t really be definitive about anything these days, but it strikes us that the concessions they’ve offered Mr. Trump are actually minimal concessions and stuff which was already in the pipeline. The troops that they agreed to deploy were already in the pipeline. The US has been strengthening their controls on their own southern border for more than a year.
Also read: Credit Markets Remain Appealing For Income-seeking Investors
I think Mexico has successfully returned the blame vis-a-vis cartels of the US, regarding the easiness with which cartels could procure themselves with heavy duty weapons. It looks like they’ve held their ground against the US. I think Trump kind of understands, thanks to the pressure he’s received from his own CEOs in the car industry. There was a meeting last week between the heads of General Motors, Ford, Stellantis at the White House.
He’s kind of understood that to a degree, imposing blanket tariffs on everything coming from Mexico would be akin to shooting themselves in the foot, given how integrated the two economies are on the manufacturing side. I’d say Mexico, and it’s striking to see that despite all the noise and fury we’ve had around these announcements, the Mexican currency has been very stable since November last year. It’s not even since the inauguration, but throughout the period, the Mexican peso has remained in a tight 4% range, which these days, is no mean feat.
Beyond Mexico, we have China, and for us, China remains a key macro input into our investment process, but there is nothing much we need from China as an investment destination these days. Since the demise of the Chinese property sector a few years back, what is China for EM fixed income investors? It’s a local bond market with a low volatility currency, low yielding bonds. Essentially, the local debt in China is a low yield, low bar, low beta contributor.
An EM debt investor these days, unless they have massive amounts in Chinese investments, they never make nor break their performance for the year, but making a mistake on China, even though China is still 10% of the local bond index. It’s about five, 6% of the external debt index, mostly because of tightly valued quasi sovereigns, most of which are investment grade, which are also very low yielding. You have to think about China more as a macro input in a global framework.
In that respect, China matters, because it’s still calling the shots on the major commodity markets. It matters because of its trading links with neighbouring Asian countries. At the end of the day, I think the Chinese have actually also understood, and played their cards quite cleverly. There was a universal expectation that when tariffs start to hit, the Chinese would need to depreciate their currencies, and that would be their main retaliation tool.
It’s been clear to us from December onwards through various statements from the Chinese leadership, that the way they were addressing the trade imbalance risk and the tariff risk was multi-shaped, looking at it from different standpoints. For them, it’s not just a tit-for-tat percentage of tariff times value of my exports to the US, or imports from the US, as it stands, as it could be the case for retaliation. They’re also looking at it from the regulatory angle. They’re looking at it from more of a strategic angle.
Are there some key components which are more strategic than others that we retain for our own consumption? The retaliation, what’s been striking is that the retaliation so far has affected a very low percentage of US exports to China. In terms of value, it’s no more than $25 billion, but they’ve really targeted it as they did in 2018, to where it really hurt like agricultural exports, agricultural machinery, all coming from only the Midwest, which are Trump’s electoral base, so red states.
They’re also considering that if you look at Chinese trade to GDP, Chinese exports to GDP, exports to the US are about 2.5% of GDP. Exports to the rest of the world are 12.5% of GDP. I think in their logic, they’ve kind of written off the 2.5% of GDP to the US. They know that one way or another, their exports to the US are going to be curtailed.
China was serious in the old narrative about rebalancing the economy, from investment to consumption. We’ve never really seen that in the figures except for a brief period of two, three years before 2015. We feel that Chinese leadership these days is not in favour of a welfare state model, which would be the main condition under which consumption could thrive and savings rates could drop in China. As a result, by default, perhaps, they’ve relied on this model whereby they build excess exporting capacity, which they need the rest of the world to absorb.
Also read: Where to Invest in Private Markets
From that standpoint, if they were to devalue their currency, that would also be inviting retaliation from other trading partners, including Europe, but not limited to Europe, perhaps other emerging countries as well. I think this is what they want to preserve. They are more focused on preserving their trade links with the rest of the world. They’ve accepted hits on their US exports, and they’re also assuming that they were so competitive on a number of those products that they export to the US, that even with a 20% price rise, US consumers will still need to buy what they produce.
It’s a fine calculation, I think they’re probably right in this assessment. It looks to us that, and there were also domestic risks of reigniting capital outflows by massively devaluing the currency as well. They’re always treading a very fine line when it comes to managing the exchange rate, and not triggering a shift in expectations from their own domestic players. They’re also in the business of trying to rebuild private sector confidence. You saw Jack Ma being taken out of the cupboard lately, and that’s clearly something they’ve realised as well.
They need a return of private sector confidence. It’s a way for them to preserve what is essential to them. They’re not overreacting, which is good news.
Then the most exposed are actually southeast Asian countries. Interestingly, the Trump administration has not yet turned to them in a major way. We’ve heard some noise around South Korea, perhaps because their trade surplus in magnitude is higher than others.
When you look at the trade structure of countries like Vietnam in particular, that’s the most striking. Vietnam is the one which since 2018, the start of the trade war has most obviously served as a rerouting base for Chinese exports. Their exports to the US, the US exports to GDP was 15% in 2018. It’s now around 25% of GDP, and their share of imports from China has equally grown by the same proportion.
It’s an obvious target to me, but they’ve been surprisingly silent on that. Malaysia, Thailand are other countries, which to a degree, have served also as rerouting routes for Chinese exports. Those countries are potentially at risk, but once again, when it comes to EM debt investors, those countries, China and Southeast Asia in general, are actually part of the lowest-yielding place, that there isn’t anything much left in Asian high yield, apart from some high yielding Indian names or Indonesian names.
A number of those names are kind of idiosyncratic, but they don’t form a major strategic segment for EM debt investors. When assessing the impact for EMs, you have to consider exports to the US, but also the degree to which China could redirect their exports to other places, including EMs, which are countries which typically are least positioned to retaliate in a major way. They’re not in a position of strength.
The issue is that on a net basis, it’s quite likely that a number of emerging countries, mostly in Africa, but also in Southeast Asia, given the trade links, would serve as a dumping ground for Chinese exports, in which case, there is a trading opportunity, which is to buy local bonds, receive interest but you don’t necessarily want to keep the exchange rate risk. From an interest rate standpoint, it’s quite friendly to us, because all of that is utterly deflationary.
We’ve long said these tariffs issues are inflationary ultimately for the US, but very deflationary for the rest of the world. We make a slight difference between countries which are both exporting to the US and importing a lot from China, in which case, it’s both a growth shock to differing degrees. Apart from the few Southeast Asian countries, the rest are, we’re talking 5%, 7% of GDP represented by Chinese imports.
It’s a, I don’t want to say a shock, but it has a negative impact on growth if their exports to the US are curtailed. Higher Chinese imports are a more of a deflationary shock. For some countries, it’s both growth and deflation. For some it’s more deflation than growth. You do have, for example, a number of countries in Eastern Europe which have a fair share of imports from China, but these tends to be more capital goods, which are used in turn to build extra export capacity for those countries, thanks to Chinese investment.
You see that in Eastern Europe these days, where there could be a case for, let’s say, the German car industry decline. We’ve seen Chinese electric vehicle makers setting up shop in the Czech Republic, in Slovakia, in Hungary. On a net basis, it’s not as bad as it seems. I’d say so far, so good.
We haven’t really seen any alteration of growth prospects at this point in EM or China. We’re still talking about a 3-3.5% base of growth going forward for 2025, which is roughly similar to 2024, perhaps slightly lower, but we’re talking of 0.2%, 0.3% lower, clearly not the end of the world.
EM – You really don’t have any major concerns about tariffs impacting emerging market debt investors at this point?
DB – For Europe, we were bracing for 25% tariffs on the European car industry. Clearly, that would have negative impacts on growth, especially in the Czech Republic, Slovakia, and Hungary. We’ve actually taken some positions to receive interest rates in the Czech Republic. The point I’m making here is that we can still make money, even if the macro scenario seems negative, i.e. less growth.
Also, central banks kind of push to loosen their monetary policy to respond to a potential growth shock, in which case, it’s good for interest rates. Interest rates are coming down, so you buy duration in these countries, and that makes quite a bit of sense. Owning Eastern European local currency bonds, versus the Euro so that you don’t take as much of an FX risk, is one way to monetise this state of play.
EM- With your own portfolios, do you have a bias now to certain EM countries? Have you changed your weighting your allocations to countries?
DB – Not so much. Mexico remains one of our largest single-country exposures. The way we think about any given country is that we come up with a macro narrative on that country, and then we flesh out this macro narrative in different trade ideas. It may be a view on the currency, which may be, say, negative, but conversely, a positive view on duration, so receiving interest rates or going long local government bonds on an FX hedge basis.
In Mexico, for example, we’ve had a lot of exposure to Pemex, a national oil company, which we feel is still very much buffered by the government. Even on a standalone basis, there’s nothing too wrong. It’s a disaster in terms of financial and solvency risk. In practice, it’s totally backstopped by the government. It’s still offering a good source of yield.
Mexican corporates have been totally unaffected by the noise and continue to carry on. We have some banks, some debt in Mexico. We have a couple of industrial names, but they’ve been almost totally immune from all the noise, which is quite striking, right?
EM – It is. You’re really saying it’s a really good picture. Despite all the fluctuations in share markets and other markets, Bitcoin, EM debt has been fairly stable even throughout this whole very uncertain period?
DB – It is stable, and clearly, as always, the key indirect impact that you need to control for when it comes to an EM debt portfolio is clearly the direction of travel on the US dollar and US yields. Ever since 2021, progressively, we’ve seen how immune EM debt risk factors were to subsequent rises in US yields. Take the latest in the 3Q24, 10 year government bond yields rose from 3.6% at the lowest to 4.8% at the highest.
We’re now back to 4.25% on 10-year US yields. The gains during that move, 3.6 to 4.8, EM’s sovereign spread, corporate spreads heightened in the face of that. This tells you EM credit outperformed US Treasuries, spreads tightened in the face of that. There was some passive type plus the carry and so you were better off owning EM debt during that phase than owning US Treasury bonds. Similarly, for local bonds, the quantum of local yield widening was de minimis.
We’re talking barely 0.2%. US yields rose by 1.2%, and in the 0.2%, Brazil, which was a very idiosyncratic story at the back end of last year, because of fiscal concerns, certainly accounted for half of that. Excluding Brazil, you can say that the landscape has been very immune to that. Now, how do we explain that?
EM – Does that mean really that if you’re a debt investor, you should certainly have an allocation to EM debt in your portfolio because of its consistent returns and its very broad diversified base?
DB – That’s exactly what we’re saying. It’s an asset class among global fixed income, which has been totally beleaguered in terms of flows over the past three years. To put things into perspective, the last real shock in terms of outflows from EM debt would be in 2013. We’ve never had a succession of three years of massive outflows from this asset class. In 2022, if I think about you have stats from EPFR, which monitors EMG mutual funds, so 3000 global mutual funds investing in EM debt.
Out of that sample, in ’22, we had $120 billion withdrawals, followed by $30 billion in ’23, and another $30 billion in ’24. It’s been three years of successive outflows. The total of those three years is six and a half times state potential, yet the asset class hasn’t performed so badly in 2023, we delivered something like 12% returns, and last year, 8% returns. This year, so far, we’re at 3%. Yes, 2022 was a very challenging year, but it was for any fixed income asset class, right?
It was the time where you had to absorb the rise of US yields from zero to 5%. That’s a permanent tax, which we only make up over subsequent years. Unless the Fed takes rates back to zero, we never recoup those losses. We just amortise them over time. 2022 was clearly a horrible year. You compound that with massive disappointment on Chinese growth, Russia’s invasion of Ukraine, so a succession of unforeseen shocks on EM debt. You had a few defaults in ’22 for some countries, but far less than expected in the end.
A few countries, Sri Lanka, Zambia, Ghana, ended up defaulting, because they were the most front-loaded debt structures, and they needed refinancing at a time where the market closed down. At the end of the day, there is a picture of resilience. Why? No one owns EM debt anymore. Asset allocation to EM debt is at rock bottom levels now. It’s very clear for me, we deal a lot with the US – 50% of our assets under management are coming from US accounts, such as advisory and pension funds. I can tell you that these guys are still at rock bottom EM allocations.
It’s less true for Europe, where the appetite, it’s very clear has always been a bit more active. I’m here in Australia. We have some accounts, we’ve built a presence here over the years. We have a local mutual fund, but I can’t say that there’s been a massive enthusiasm for EM debt, even though Australian investors have a unique advantage, especially when it comes to local currency debt in the end, that when everyone in the dollar space complains about massive volatility of the EM currencies versus the US dollar, the Australians have the chance to have a currency that correlates quite well with EM currencies.
We hold EM local currency assets directly versus the Australian dollar, which means that we are eliminating the volatility into the strong US dollar.
EM – Very interesting.
DB- We are repeating the cycle, right? That’s a unique chance for Australian investors when it comes to approaching one part of the EM debt, which is supposedly for many others, quite toxic because of the volatility associated with currency risk. Leaving that aside, I think this absolute lack of ownership by global investors means that a lot of those markets are now, local markets for sure, massively owned by domestic investors who do not respond as much to currency signals in terms of inflows and outflows.
Most of them, their appetite is driven by solid buy-and-hold demand, because the balance sheet of banks, pension funds, local insurance companies has been growing much faster than GDP over the years. That’s now serving as an anchor for many local markets. What’s interesting is also that holdings of their own external debt has also increased quite a lot.
Colombian banks, Filipino banks, Brazilian banks are big holders of Colombian dollar debt, Filipino dollar debt, Brazilian dollar debt. I could expand on other places like Chile, Poland. It looks like foreigners have withdrawn.
EM – Domestic investors have stepped up.
DB – Locals have stepped in, right, which provides an element of stability. Brazil is a big country in our universe. Brazil was under pressure last year, mostly at the hands of their domestic financial community, which kind of lost confidence. I think it’s coming back now. It’s stabilising, so there have been massive moves in Brazilian local debts and currency, yet we never saw the contagion anywhere else.
You can have episodes of acute macro pressure, like that in Turkey three years ago, because of policy mistakes. You can have episodes of macro stress on one given EM country, but contrary to what we had like 15 years ago, where losses in one country entailed profit taking on other countries, hence the contagion, these days, all of those countries are fairly isolated. It’s true also for the riskiest part of our universe, which are not the big countries anymore, Turkey, Brazil, who can moan about some policy credibility issues here and there, but none of those countries is ever at risk of imminent default or complete collapse.
If you’re really looking for default risk, you have to go into the frontier space, those smaller countries. This is where you can still find countries which are kind of borderline, which risk tipping into default at some point. It was the case in ’22. Fortunately, today, IMF support, and a lot of bilateral support from Gulf countries assist EM countries. A number of those borderline countries have actually turned around super positively with a very convincing path ahead in terms of future positive goalposts.
No one owns the debt of Ukraine these days, or Ecuador, or Argentina, without knowing why they own the position. Point being that we don’t see any tourist money anymore in those countries, this type of hot money and weak hands, which can dump these bonds at short notice. It’s probably an explanation as to why this part of the market is a bit more enduring, populated by people who do their homework on restructuring potential. Not everyone needs to have the same view.
You do have volatility when sentiment shifts, and that’s the case for Ukraine. We’ve had a negative election surprise after the first round of elections in Ecuador, which meant that suddenly, the repricing of the new scenario meant the bonds had lost 20 points in a few days. You need to brace for that. You need to calibrate your position so that if that happens, you don’t lose your shirt.
EM – Equally, Damien, you wouldn’t, I don’t imagine have a big chunky exposure to Ecuador in your portfolio?
DB – Exactly. For us, it’s all a matter of carefully calibrating those positions, which could give you big capital gains, but potentially big capital losses. Have room to express your conviction, but I’m never going to put 10% of my portfolio in Ecuador.
EM – Just thinking about the year to come, what sort of returns do you expect investors can achieve in emerging markets?
DM – I’d say, absent an extreme scenario, we’re in a range trading mode on US yields on the dollar.
I think, the US economy can still technically go into recession for one or two quarters, but is that the end of the world? We have recession and recession. A recession that really feels like a recession, I don’t believe it. Absent catastrophic scenario in the US economy, I think we are okay. EM debt is up 3% today. I think there are prospects, for EM corporates versus US high yield at every rating level, in terms of default probability being much lower, credit metrics being much better.
The spreads you’re being paid in excess of US high yield is actually tremendous value for money for the risk you actually take. Few people realise that, but I think we could get close to slightly above double digits still this year.
Which is similar, to last year. I think carry is your best friend again. It’s boring to say that, but we’re in an environment where appetite for yields is overwhelming, and that’s true for any credit asset class, but it should be even more so for EM debt. Even if you see a small return of inflows from global investors, it’s going to have a massive impact on valuations.
It could really push the market much higher. I think there is scope for that when investors decide that, “Okay, the worst has passed in terms of Trump-related noise.” We are bracing for that. We’re seeing a lot more interest and inquiries than we’ve seen in the past three years at the moment. To me, it’s entirely possible that it comes to around two digits, say a high single, low double. That’s perfectly possible.
