Emerging-market (EM) debt rebounded strongly in the second quarter across hard currency sovereign and corporate credit as well as local-currency debt.

Bradford Godfrey, Institutional Portfolio Manager Director of Alternative & Asset Allocation Strategies at Eaton Vance says: “We believe the market has entered a new phase following the broad-based recovery in the second quarter that will see greater differentiation in performance across the EM debt investment universe. In our view, a focus on country analysis, investment flexibility and the ability to appropriately weigh shorter and longer-term factors will be critical for investment success in EM debt ahead.

“While we see attractive relative value at the sector level in EM credit, we believe that selective opportunities remain in rates and currencies away from many of the large benchmark constituents.”

In a broad sense, the outlook is rather challenging. The IMF recently revised GDP forecasts down for EM by two percentage points, to -3.0%. For several bellwether countries, the outlook appears far worse. For instance, India’s GDP forecast is at -4.5%, Russia’s -6.6%, Brazil’s -9.1%, Mexico’s 10.5% and South Africa’s is -8.0%.

Godfrey says: “These countries, which typically grow at a decent rate, often define the general narrative for emerging markets as a whole. While these core countries are really in a quite a difficult position, we must also remember that the emerging-market debt opportunity set is formed by a much broader universe of countries.

“Egypt is one country within the wider opportunity set where we see opportunity. The country is expecting positive growth in 2020, bucking the wider EM trend. The high fiscal deficit (7.6% of GDP) needs to be monitored, of course, but we must note that Egypt was already trying to address budget issues before the pandemic. In our opinion, the country is managing the crisis reasonably well from an economic perspective, having put in place many temporary measures, which we find reassuring.

“Other countries we’d highlight include Romania, Uzbekistan and Uruguay. Although Romania faces an economic contraction, forecast at -5%, we believe relatively healthy debt metrics will help the country weather the current storm. Uzbekistan, for its part, is a country that’s not on many people’s radar. However, Uzbekistan’s growth forecast is positive, the budget deficit is manageable and its reform-minded leaders have been moving toward a more market-based system.

“Similarly, Uruguay’s government has also been implementing reforms, even in the midst of the pandemic. While the growth outlook appears somewhat challenging, like other parts of the region, the country has taken steps to move forward a sustainable reform program.

So how does the outlook look from an investment perspective?

“For starters, we believe the broad-based rally is now over and that we’re entering a period of differentiation. In this environment, how one invests in EMD is going to be critically important, in our view.

We are focused on three areas:

1. The critical role of country-level analysis
2. Investment flexibility, geographically and in terms of risk factors
3. Balancing short-, medium- and long-term factors

“On the first point, we believe that fundamental analysis is always critical, but all the more so in a period of differentiation. With the pandemic not over, we are closely watching how countries confront the virus to protect the public and manage their economies.

“Policymakers are trying to maximise economic output, while not overrunning health care systems. It’s become a calibration process, with variations in levels of effectiveness by country. In our view, many of the bellwether countries mentioned earlier are not managing the process well, while other smaller EM countries are doing relatively better.

“In terms of investment flexibility, we believe that exploiting the full breadth of the EMD investment universe on a country and risk-factor basis will remain a critical factor for investment success. Within the EMD universe, investible risk factors include currencies, local interest rates, and sovereign and corporate spreads.

“At Eaton Vance, we take active positions only in the risk factors for which we believe we will be adequately compensated, while at the same time trying to eliminate unintended exposures, through hedges if necessary.

“Thirdly, while we are medium-to-long-term investors, the situation in global markets at present is still very fluid. In this respect, we believe it is prudent to weigh short-term factors appropriately, possibly giving them greater weight, while EM debt markets remain dynamic,” he notes.

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