Stephen Rudman: Good day, today is Tuesday, July 11, 2023. Welcome and thank you for joining Ashmore's ‘EM in 10’. My name is Stephen Rudman. I'm part of the New York client facing team for Ashmore. Today we have Gustavo Medeiros, our Global Head of Research, to discuss the first half of the year as it relates specifically to Emerging Markets (EM), as well as providing a more global view.

Gustavo, as always welcome, happy to have you. To start, can you just give us an overview of markets in general for the first half of the year?

Gustavo Medeiros: Absolutely. Markets were very strong in the first half, surprising many analysts – including the one that you're hearing from right now.

Just to set the scene, we've seen the VIX volatility index go down to 13% at the end of June. That is down from 22% at the beginning of the year and a high of 30% in March, at the time of the Silicon Valley Bank (SVB) collapse. At the same time, the yields on US Treasuries also went up quite significantly. That has been the backdrop for the US economy accelerating and performing quite strongly, particularly towards the second half of May and June.

This strong economic performance was very much related to the service sector, which has been buoyed by the savings accumulated during the pandemic, but also by the extraordinary amount of fiscal expansion that took place post-pandemic. Quite a lot of that was the cost of living adjustment, which basically meant some 100 million pensioners and receivers of social benefits got a close to 10% pay rise in January of this year. But other fiscal measures were also announced, like the Inflation Reduction Act and the CHIPS Act which

boosted semiconductor investment in the United States (US), obviously helped to buoy investor sentiment. There was also the frenzy for Artificial Intelligence (AI) which boosted US tech stocks. If you look at the NASDAQ for example, it went up by 39% in the first half of the year, with close to 21% of that performance taking place in June.

And against that backdrop, interest rates were increased again, because central banks remained on the hawkish side. One-year rates in the west went up by 71 basis points (bps) to 5.4%. Two-year rates rose by 47bps to 4.9%, and ten-year rates actually declined by 4bps to 3.84%. So, the curve has flattened and inverted to close to record levels of inversion,  which is typically not very good on a forward-looking basis.

Against that backdrop, EM did relatively well in the fixed income space. EM sovereign debt went up by 4.1% with high yield outperforming, obviously, as yields on US Treasuries widened – which is a headwind for investment grade. Investment grade still did quite well, rising by 3.1%, but high yield rose 4.3%. Interestingly, 4.1 out of the 4.3% of this performance came in July. Local currency bonds massively outperformed. They went up by 7.8% in the first half of the year with EM foreign exchange (FX) rallying 2%, and the rest explained by EM rates tightening. EM rates actually decoupled from the global rate environment, whereas as I mentioned, five-year rates went up by almost 50bps in the US. In EM, local currency bonds went down by close to 50bps. Yields went down from 6.85% at the beginning of the year to 6.32%. And if rates are declining now in the US, EM rates still have some room to come down, to the extent that some EM countries are likely to start cutting policy rates earlier. But overall, it was a pretty strong first half of the year, with outperformance from some of the growth part of the markets that, in our view, shouldn't really be outperforming. The discrepancy between valuations has just increased.

Stephen Rudman: Excellent, thank you, Gustavo. Can you highlight one or two areas specifically in the EM space that were intriguing to you in the first half of the year?

Gustavo Medeiros: Yes, there were a few very interesting developments in EM to highlight. First, a number of Frontier Market countries that had been in a complicated situation in terms of their debt sustainability analysis managed to implement some important structural reforms.

For example, Nigeria’s new President-elect came out of the gate announcing two extremely important reforms. He allowed the Nigerian Naira to float and he also cut domestic subsidies for gasoline and diesel prices. Both of these were very important reforms to allow for the liberalisation of the most important prices on the economy and potentially encouraging stronger economic growth. Both on the fiscal side and for Nigeria’s external accounts, that is going to be very positive. So, Nigeria implementing very tough reforms.

We also had some announcements of very strong fiscal consolidation from Kenya, and Zambia kept on pushing for a fiscal consolidation. Very interestingly, Zambia announced a deal on its bilateral debt with China. Zambia owes about USD 7.8 billion to various Chinese entities through various Zambian entities and local governments. So, it's a pretty complex deal that has been under discussion for a while. But this deal is interesting as much of the debt restructuring of these Frontier countries have been problematic to the extent that China has requested to be treated favourably and has not allowed for a debt restructuring. With Zambia, this was the first case where China has agreed for a debt extension coupon reduction that implies a 30% to 40% decline on the net present value of the Chinese debt.

There's also an interesting provision that should Zambia’s credit worthiness improve according to the International Monetary Fund (IMF), and if its risk of credit distress goes from high to medium, China is going to be allowed to collect higher coupons and sooner, which would improve the net present value of the restructuring quite significantly. I think is an interesting framework potentially for some other debt restructurings. There are other countries with IMF deals like Egypt, which also had a currency devaluation in Pakistan.

So overall, the Frontier space ended up the first half of the year on a much stronger footing than it began, and in particular some of the complicated single-B names started to look attractive given the recent developments.

The other interesting development, obviously, was local currency bonds outperforming dollar-denominated debt for the first half of the year, as I mentioned. And it was quite a strong outperformance, almost twice the performance, and we think that this is a trend that can have more legs. Local currency bonds have been oversold for a while and investors – particularly US dollar-based investors -  have been disengaged with the asset class, not only from the US but from the Middle East and from Asia. But the outperformance, plus the fact that we think several EM countries are going to be leading the monetary policy easing push, are likely to be pretty positive for this part of the asset class.

Stephen Rudman: Thank you, Gustavo. Very helpful. Perhaps most importantly as we sit here mid-year, what do we think is out there in the second half? Obviously, you don't have a crystal ball, but if you can share your thoughts.

To allude back to your predictions for 2023, you had called it ‘a tale of two halves’. While we’ve certainly seen a bumpy first half does that prediction still hold true? Do you still think the second half may prove a little better, or six months into the year, have things changed?

Gustavo Medeiros: Yes, it's interesting. The ‘year of two halves’ played out until March and then when we had the banking problems in the US, followed by a massive bounce back. It reminds me of how Bear Stearns was a catalyst for a massive relief rally, in the midst of the global financial crisis. So, I'm still a little bit cautious on the global macroeconomic space. There's still many risks looming.

Of course, interest rates rose to the highest level since the SVB crisis, and interest rates increasing to all-time highs is typically pretty bad. It leads to accidents and central banks have been very, very hawkish. The Bank of England (BoE), for example, delivered a 50bps hike at its June meeting and the central forum in Sintra, Portugal, saw the European Central Bank (ECB), the US Federal Reserve (Fed), and the BoE making very hawkish statements.

Also, liquidity has been tightening quite aggressively since April. We had some liquidity easing as a result of the SVB crisis. In fact, back then there was quite a lot of targeted liquidity going into the financial system that backstopped the problem. But since then, liquidity has been tightening significantly. I would highlight that there was almost EUR 500 billion of TLTROs (targeted longer-term refinancing operations), basically ECB funding to banks that expired on 28 June, and the ECB has stepped up its quantitative easing.

Meanwhile in the US, the debt ceiling agreement allowed the US Treasury to issue debt at  quite a fast pace. As a result, the Treasury General Account has already been replenished by almost USD 400 billion,  and that was primarily the issuance of T-Bills. The US has been acting as an EM economy, issuing much more debt at the front end of the curve, which is where investors have more demand but are paying a higher price for debt.

So, this liquidity tightening typically doesn't bode well for risky assets, particularly as we look into the summer, when some of the fiscal measures start coming into force. For example, students haven't been paying their student debt, both principle and interest, in the US since March 2020, after an amnesty was put in place. And at the beginning of the year, President Joe Biden published a bill where he would forgive most students of repaying USD 10,000 of principle in student debt. But in June, this was struck down by the US Supreme Court. That decision could prove problematic as 26 million Americans that already subscribed for that debt forgiveness are now going to face a bill they didn't have before.

On top of that, interest payments are set to restart, with interest accrued in September to  starts getting repaid in October. So, there are still quite a lot of headwinds.

Obviously, the housing market uncertainty caused by higher interest rates is still playing out in places like Scandinavia, Europe, Australia, Canada, and to some extent the US. However, the US has been largely insulated because most individuals have 30-year mortgages so their effective mortgage rates didn't increase at all, although 30-year mortgage rates went up from 3% to 7%. Also, the commercial real estate market is going to be very interesting to monitor this week as we start getting the earnings cycle coming through.

Now looking at the US compared to EM, what is interesting is that the US equity market rally came through in a very unusual way. Earnings per share was down by 5.8% in year-on-year terms, but the price-to-earnings (P/E) multiple ratio increased from 18 times to 21.3 times. In the previous four recessions, the P/E multiple troughed at around 16 times. Today, we just had a massive rebound or repricing on the P/E and we're likely to see earnings pressure declining further, up to 7% year-over-year, on the second quarter of the year. This is what is expected by consensus, and analysts expect a rebound from here.

So, we need everything to go right for US stocks to perform well, which makes me double-down on my view that EM stocks should have much more room for outperformance. This is because EM stocks had an earnings per share contraction as expected, but the multiples didn't increase at all. EM stocks went up by about only 4% or 5% on a year-to-date basis. This means the gap between US and EM stocks has widened much more. I think it is a tremendous opportunity for investors to get away from very overpriced assets with some elements of mania taking place again, similar to what was seen at the end of 2021, and to invest again in good value assets with much more potential upside in the medium term.

So yes, the ‘year of two halves’ didn't play out, but it’s always hard to forecast exactly how things will go, it’s always path-dependent. I think that the combination of more aggressive fiscal accounts and these, temporary liquidity injections post-SVB crisis, and AI mania, were the key fundamental reasons for us to miss the nuance of the call.

But I'm still very much committed to the view that held at the beginning of the year that EM stocks should outperform US stocks. We also had EM local bonds as most likely outperforming dollar-denominated debt, and so far, that view is playing out quite well. I would also double-down on the view that investment grade assets look good value, and the widening of interest rates make this part of the fixed income asset class very attractive, particularly for the second half of the year.

Stephen Rudman: Excellent, thank you. We look forward to seeing if this all plays out. It's been a particularly wild ride, lot of news, so to get a view on areas that are positive, and areas of opportunity, is great. As always, thank you Gus, I hope you continue to enjoy the summer, and I wish the same for all those watching. Thank you all.

Gustavo Medeiros: Thank you.