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Stephen Rudman: Good morning and good afternoon. My name is Stephen Rudman. I'm with the client-facing team in New York City. I would like to welcome everybody. I hope everybody is enjoying the change of seasons and are off to a happy Fall. 

Today's webinar is titled, “Surviving the Autumn Blues: EM Sovereign Debt Fireside Chat”. Sadly, we don't have a fireside, but with that said, our players for today are Alexis de Mones, who is our Emerging Market Debt Portfolio Manager, and Gustavo Medeiros, who is our Global Head of Research. The discussion is going to cover a lot of things here, but today is really about Emerging Market (EM) debt, specifically on the sovereign side. But we'll cover lots of topics and things from a global perspective I'm sure are on everybody's minds. With that said, we should be about 25 minutes, so, not too long. Gus and Alexis, welcome, and I turn it over to you guys. Thanks so much.

Alexis de Mones: Thank you, Stephen. Welcome too, Gus, for this update on external debt today. I think first we want to lay out the scene in terms of the fundamental backdrop. EM debt has performed quite well recently. Can you walk us through the economic fundamental underpinnings of that good performance, and what you see happening going forward?

Gustavo Medeiros: Thank you, Alexis. We've been discussing the fundamentals for a while now, but I think there are a few points important to highlight. The first one is that gross domestic product (GDP) growth differentials have been improving in favour of Emerging Markets. GDP growth differentials between EM and DM were around 1.5% in 2022, and moved to around 2.5% both in 2023 and 2024. So, this increase in the growth differential is quite important across asset classes, because you typically have risk premium tightening in that environment. And, as you pointed out, that was one of the catalysts that started driving better returns of EM fixed income vis-a-vis Developed Markets (DM). 

The other catalyst important to mention is that the US dollar peaked in Q4 2022 and has been on a declining path since then. Obviously, there’s been quite a lot of volatility in that, and more recently the dollar is trying to strengthen at the margin as some of the cuts from the US Federal Reserve (Fed) get priced out. But we find it very hard to believe that the dollar is not going to be declining further within the next couple of years. And as the dollar weakens, that typically leads to further risk premium tightening between EM and DM. The depreciation of the dollar also leads to an improvement in liquidity conditions for EM countries as when the dollar weakens, there's more capital flow into the rest of the world. 

These better fundamentals have been more recently reflected across rating agencies. We have had all three rating agencies upgrading more countries than downgrading in 2024. This has been led by S&P, which since 2022 has been upgrading more EM countries than downgrading. Fitch was catching up in 2023, and now Moody's finally is also upgrading more countries. It’s important to highlight that all three rating agencies have more countries with positive outlooks than negative outlooks. 

Finally, three other quick points. On the global economy, in the G20 we are seeing a slowdown. From the very shallow expansion that started in Q4 2023, we've been getting a very shallow acceleration since then. That's been improving a little bit in Q3 this year, over the last three months, despite the fact that we are seeing a slowing down, and that slowdown is likely to have more legs. 

Shallow expansions typically lead to shallow slowdowns and recessions as well. That's particularly important when you consider that central banks have a lot of room to add stimulus. So, even if we go towards a slowdown phase and a recession, that's something that should actually not be super-negative for the asset class, which is something that’s typically a concern for investors. I think those are the most important points. Obviously, there's also the US election dynamics, which is something that we're likely to talk towards the end of the webinar.

Alexis de Mones: In terms of these countries that either got upgraded or are candidates for upgrades, can you mention some of the most prominent ones and explain what sort of economic policies they've implemented to achieve these better ratings profiling? 

Gustavo Medeiros: In terms of rating profile, we published a piece in June with quant work around which countries that are likely to be upgraded and downgraded in the future based on economic data relevant for ratings, such as economic growth, the ability to service debt in terms of primary deficit, but also importantly, interest payment to revenues and also external accounts, the current account deficits.

We identified a group of 24 EM countries with solid market access and these are market-access countries that are upgrade candidates. So, some of the countries we flagged as potential upgrades have already been upgraded since then, including Türkiye, Brazil, Oman, Azerbaijan, Kazakhstan, and Croatia. Whereas Oman and Azerbaijan are actually important ones because they got the first BBB- rating from one out of the three rating agencies. Som those are two countries that are potentially going back to the investment-grade universe, which suggests we are turning the corner, right? 

Since 2012, we've seen a lot of fallen angels and not a lot of countries upgraded. Then, we have about seven to eight countries that are downgrade candidates within the market-access universe. One of the examples there is Kenya, which we flagged and it got downgraded. Israel and Senegal were other notable downgrades. But the list is obviously one-third in terms of potential upgrades to downgrades. In the distressed space, there are 12 countries that are candidates to upgrade and only three countries that were downgrade candidates. We could actually have had a fourth there, but we're talking again a very big net upgrade potential. Tunisia is a good example of a distressed country that recently got upgraded. 

Alexis de Mones: So, the policies that have led to that, usually you're talking about fiscal consolidation that the rating agencies welcome. Sometimes you have external developments that are helpful in terms of the balance of payments. Sometimes it's a devaluation that leads to much better liquidity. Amongst those three main policy developments or economic developments, which are the ones that you think have been dominant in the space that have underpinned those upgrades?

Gustavo Medeiros: I think the notable change we've seen in the economic environment that allowed for the upgrade was the fact that if you look at GDP growth in dollar terms, many countries have had a much better environment over the last five years. 

We're looking at 2019 to 2024 compounded average growth rate improving significantly from the prior five years (2014 to 2019). That's despite the pandemic. So for example, Azerbaijan, the dollar GDP growth was -8.5% from 2014 to 2019 and improved to +10% from 2019 to 2024. Brazil moved from -5% to +5%, Kazakhstan from -4% to +10%. So more stable FX dynamics, as you mentioned, obviously played a pretty big role, but economic activity also have improved in local currency terms. And in many of these countries, we've had actually structural reforms implemented, sometimes just prior to the pandemic, sometimes around or post the pandemic, that have allowed for better dynamics. Also, if you look at the other ratios, debt-to-GDP, the primary balance, and the ratio of interest revenues, we've had some mixed bag there. Some countries have had an improvement or deteriorated, but it has been a bit more marginal. 

I would say the overall ability for most of these EM countries to service the debt did not deteriorate as quickly as seen in the developed world, and despite the pandemic. Importantly, external accounts have improved across most countries. So overall, you have much better debt sustainability, that is debt-to-GDP or whatever ratio that you want to compare, improving growth helps significantly on the deleveraging task. 

That covers the fundamental backdrop, and some of the nitty-gritty work we've done. You can find the data that we mentioned again on our website. It's a piece from June called "The Untold Story of Improving EM Fundamentals." 

Alexis, tell me a little bit about the market structure going forward. Where do we see value? Maybe we should start with investment grade.

Alexis de Mones: I think it's useful to look at investment grade and non-investment grade as separate. We are talking about an asset class that's become quite bifurcated with a contingent of countries, about 20 of them, that have been rated investment grade and that have maintained their investment rating. These countries have effectively withstood three years of the downgrade wave because of the strength of their fundamentals. And this group of countries still rated investment grade have very strong economic fundamentals, particularly very low general government debt levels of on average 48% of GDP. 

So, the fundamentals are important there, and because of these fundamentals, they've attracted a lot of sponsorship from global investors, including insurance companies and pension funds, that are natural investment-grade buyers. Now, when we talk about the Emerging Market Global Bond (EMBG) Index, it's effectively, it's 50% investment grade and 50% high yield. So, sometimes investors get a bit confused. They don't know what they're buying when they buy EMBG because half of it is investment grade (IG), but half of it is high yield. And what is in the high yield space is extremely diverse, and again it goes from IG upgrade candidates to a number of CCC and distressed credits, which we'll touch upon later. 

In the investment-grade space, it's very healthy, has remained very healthy, and the performance there has been strong on a spread basis and has been strong also on a long-term basis. So, to just mention a few metrics, 5.3% yield-to-maturity for the IG part of the universe. It's effectively exactly the average since 1 January 2000, the last nearly 25 years.

So, you're at the long-term average in terms of yield, and over that period, the return itself has been close to 5.3% as well. This is a number to keep in mind. And if you look at the last 10 years where we're trading 100 basis points above the last 10 years yield-to-maturity for IG, and here the performance over the last 10 years has been quite good. For a period, duration was helping, and when duration was not too helpful, then they withstood the market trend as well. So the performance has been 3.7% over 10 years, which is 200 basis points above the US Aggregate Index, right? So IG has really been a source of stability. So, we're keen to talk about it to dispel this impression that the asset class is all blood and sweat and tears. 

Obviously, the high-yield part has been going through a very different experience for investors, with some credit accidents over the last three years. But these are the things I wanted to start by saying, but we can continue with a short description of the investment strategy. You asked about sources of value. I want to bounce back to what you had recommended about a year-and-a-half ago, which is to invest in the barbell EM. In hindsight, there is a version of the barbell that's worked pretty well. It was the barbell with a healthy amount of CCC and B. There is also a barbell that hasn't worked so well – if you were investment grade plus a little bit of BB, because the difference between BB and BBB over the last year, for instance, has really not been all that different. The BBB has done well, about 15% returns over 12 months, and the BB only 17%, but the CCC has delivered a 49% return over 12 months. So, really, I think the barbell intuition there is you had to be brave, and back in late 2022, you had to accept some exposure to high-yield, including the distressed base, because that's where the value was. That message was a very strong one, and you had to stay the course. I'd say this year, high yield continues to perform well because the ratio of high yield spreads are still about five to six times wider than investment grade spreads. So, still value in high yield.

Gustavo Medeiros: It sounds like for the third consecutive year we're likely to be recommending the barbell, right? It's also interesting that if you look at the ratio you mentioned of spread of high yield to investment grade, obviously it's very high, but includes the defaulted securities. This ratio is also quite elevated even if you get the high-yield assets excluding the defaulted securities, right? So that's a space where you have a much higher all-in yield to maturity, which is obviously very, very important at this stage of the cycle. 

So yes, it sounds like you are nudging me on the 2025 outlook to recommend for the third consecutive year to keep on the barbell but do some adjustments. I think that's the important one. Tell me a little bit about the high-yield space. There's quite a lot of noise when you open the Financial Times newspaper, or some of the multilateral publications, of various countries in difficulties. We're about to get an International Monetary Fund (IMF) meeting the week after next. So this noise is likely to continue. Tell me a little bit about these more distressed environments.

Alexis de Mones: It's obviously been dominating the EM press coverage, the difficult challenges faced by the low-income countries that were first confronted with COVID challenges and then the balance of payment shock following the war in Ukraine. These countries had to find sources of capital which were not provided by the market because from 2020 to 2023, a lot of countries were losing market access. Those countries, in the grand scheme of things, are not a very big part of our universe in terms of investment, but they are a large number of countries. 

So, the IMF looks at this group of ‘trouble children’ low-income countries. There are 73 of them, I believe, and a number of them have had to go to the IMF due to the lack of alternative sources of capital over the last three years. Some have restructured their debt. Now these countries, I believe it is 73 countries only, represent 4.6% of the EMGB. So it's 4.6% of our index, and it's 80% of the press coverage on EM debt. I think it's very important to look at these countries and to understand the role of the buyer or the lender of last resort, the IMF being one of them. But we also have other sponsor states that have been bilateral lenders that have been generous with their liquidity provision and have helped the likes of Pakistan, Egypt, and others to turn a difficult corner. But these countries are not a big part of our universe. They are just a big part of what we talk about to clients that are concerned about the credit profile of our universe.

Gustavo Medeiros: Very good. Can you give us some examples of countries that are in that space? Obviously, we know the countries that got into trouble after COVID: Argentina, Ecuador and Lebanon, and then followed by Ukraine: Zambia, Ghana, Sri Lanka, and Ethiopia. Those countries effectively defaulted. Most of them have since restructured or are wrapping up, as we speak, the restructuring process. But what about this 4.6% group of countries? Give us a couple of examples.

Alexis de Mones: Most of sub-Saharan Africa are in that space. That goes from Yemen, Somalia, which are really not even tradable assets, but they are part of this universe, to recent defaults such as Sri Lanka, or even El Salvador. But these are small index constituents at the minute, despite the good performance of those credits recently.

Gustavo Medeiros: That's an interesting element because, again, it's very small part of the overall asset class, but it takes a lot of time from share of mind. This is where you probably want to have a lot of zero exposures and some concentrated overweights in countries you think they're going to do well, right? I know for a fact that we have zero exposure in places like Bolivia and Cameroon, which are probably both on this list. And we have a not big overweight position in some other countries like Gabon, which are still going through fighting to improve its debt metrics, and Ghana that just restructured.

Alexis de Mones: Out of these 73 low-income countries, I think only 15 countries actually have debts, so that's why it's only 4.6% of our index, right?

Gustavo Medeiros: But still 15 out of 70 is still quite a lot of countries. What about the other 44% that are mostly growing concern?

Alexis de Mones: Well, these are not the low-income countries but that are in the so-called EMDE universe, right? I think following the IMF definition, within Emerging Markets you have 150 countries, and 73 of them are low-income countries. The remainder, about half of them, are classified as Emerging Market and Developing Economies (EMDE) according to the IMF. Out of these, to get a picture in terms of economic importance, China obviously is a huge part of it. But on average, all of these 70 countries out of the 150 countries that are in EMDE, they have a current account surplus. And they have a current account surplus whether you include China or not. So it's interesting that from an external perspective, they're not really reliant on foreign capital flow anymore. Over the last decade, they’ve addressed their external dependence on capital. It's only those few, the low-income countries, which as a share of GDP are very, very small, that are still dependent on foreign capital flows. 

Gustavo Medeiros: Very good. Yes, just to wrap it up, and again tying it into the fundamental work that we published in June, some of these countries are actually candidates for investment grade upgrade, like Azerbaijan and Oman as I mentioned, but also Morocco and Paraguay. Some of them are candidates to upgrade within the BB space like Dominican Republic, Costa Rica, Guatemala, and Ivory Coast, which is a tremendous story within sub-Saharan Africa. Some of them could be migrating from the B space to BB like Türkiye and Bahrain. So there's quite a big universe here, and again, these are the core countries that are within the high-yield space that has much less risk. Overall, it feels like the barbell strategy remains a winning strategy, it just needs to be recalibrated. So, can you give me the big picture of why this barbell strategy works, and why we should keep it in the portfolios?

Alexis de Mones: A year-and-a-half ago, everything was cheap. The CCC was by far and away the cheapest, in the 90th percentile in terms of pickup in CCC versus B. You are in the 90th percentile in terms of pickups, so that was really attractive to go down the credit quality spectrum, whereas to go from BB to BBB, you are still picking a nice spread pickup but you were in the 50th percentile, so not the widest. 

However, now, all of these numbers have compressed. You're no longer in the top percentile in terms of pickup. And the spread pickup from BBB to BB is now 82 basis points. I think that's attractive in basis points terms. But in terms of historical trends, we're no longer in the decompression market environment. So, 82 basis points is above the 30th percentile of historical pickup. Now, do you want to go and effectively move away from a duration-sensitive asset, like an investment grade no-default asset into a BB to pick up 82 basis points when effectively you can maybe have a smaller allocation to B and select CCC? I think you've described where the opportunities may lie. And while these opportunities are no longer as obvious as they were everywhere, if you go from B to CCC, you're still in the 70th percentile in terms of pickup. So, I think in terms of pickup, it's still attractive to go down the credit spectrum purely from a historical yield pickup perspective. What we do obviously is select credits, not select ratings categories. So these are all general considerations. 

Gustavo Medeiros: There are also two other factors I'd like to mention here that I think are important. On the big picture, when you look at the high-yield space, you still get about 400 basis points over the US Treasury yield, even excluding the defaulted securities, right? So we're talking about 8% yield, which is almost 50% of the yields on a forward-looking basis are coming from Treasuries and 50% coming from the credit spread. In the investment-grade space, we're talking about, as you said, 5.3%, and credit spreads are only 115, 120. So the investment-grade space is very attractive on the overall all-in yield because you're going to get a decent return and sleep well at night. 

But if you add exposure towards the high yield, then again, if you take another layer of debt as an active manager, and you find the right spots, the right distressed credits, the right restructuring stories, then we can obviously build a portfolio that is much closer to a 50-50 risk parity, or 60% risk-free and 40% credit spreads on the overall EMGB, but again can improve towards the 50-50, which again, that explains why this asset class has tremendous long-term performance and why when you're getting the annual yield-to-maturity on an overall asset class at 6.7%, that is probably much better than quite a lot of the total returns on other asset classes across the world. 

Stephen, do we have any questions from you or from the audience?

Stephen Rudman: Yes, indeed, we do. First, what is the potential impact of the upcoming US election, barely a month away, for EM sovereign debt? Second, obviously we've seen the inflection point or the beginning of a change in US monetary policy, so what's the impact as we move forward? If you can handle those two together, that'll cover the questions that we've received. Thank you.

Gustavo Medeiros: Starting with monetary policy, obviously it's a tailwind for the asset class to the extent that yields are compressing and is a particular important tailwind if we do get the Fed easing monetary policy at the margin, and despite that, we don't have any significant slowdown of global activity. The danger for risk assets is if the Fed is cutting very aggressively because of a strong recession. But as I mentioned at the beginning of the presentation, I think we are in an environment where, after a very shallow expansion, we're likely to see a relatively shallow downturn and recession as well. The fact that the Fed started with 5.25% to 5.5% policy rates at the beginning of the easing cycle gives them a tremendous amount of ammunition. And other central banks around the world also have a lot of ammunition. It’s worthwhile mentioning that China has also deployed its monetary policy ‘bazooka’, which helps on the global reflation story, or at least to backstop the ongoing slowdown in China that has been a negative element at the margin. 

Now on the US election. In July we wrote a piece about the US election and right now it’s a coin toss. It's very, very hard to call who is going to be the winner. There will be quite a lot of noise, and people will try to trade the very different outcomes if Kamala Harris wins or if Donald Trump. People perceive a Kamala Harris administration as being much more benign for Emerging Markets. I think this is particularly true if she ends up hiking the corporate tax for American corporations and reducing this exceptional, positive environment for US corporations. Having said that, even if Trump wins, I don't think it's going to be that negative for EM. When Trump won the 2016 election, within the first couple of weeks, the EMBI was down 5%, and people were really worried about Trump's trade war against China. Back then, obviously Mexico was also a big threat because Trump was renegotiating the NAFTA towards USMCA. But if you look throughout his presidency, in 2017, we had a pretty strong rebound, and the EMBI rose by 13%. Overall, over the four years of the Trump administration, the EMBI went up by about 6.3 percentage points per year. So it had a pretty solid performance, and that's despite the fact that we had a massive disruption, the pandemic, during the middle of his administration. So, there was quite a lot of noise coming to Emerging Markets, but this asset class specifically performed relatively well. 

I think that this time around, what Trump, JD Vance, Robert Lighthizer, and some other people rumoured to be within his administration are talking about is to use a threat of tariffs to get a better deal out of the countries with a very large trade surplus against the United States. Think about Japan. Think about China. Think about Germany, Taiwan, and South Korea. What the Trump team has been talking about is to threaten to impose tariffs on an increasing basis, perhaps, if these countries do not revalue their currency against the dollar. So, these gentlemen that I mentioned, think that one of the factors or one of the key factors driving the trade deficit in the US is that these countries have been unfairly devaluing their currency, what some economists call ‘beggar-thy-neighbour’ currency devaluations. So, we do think that at the margin, they're going to try to use, if Trump wins the election, these tariffs as a threat to lower the trade deficit rather than just go and increase tariffs by 60% against China and 20% against the European Union without trying to negotiate anything in the background. And if that happens, if the dollar is weakening, that's a very strong environment for EM, as I mentioned, right? Because that typically means investors would be diversifying capital away from the US to the rest of the world. 

That obviously is a boon for local currency assets, but it's also positive for investors that are more conservative, and they want dollar asset class because it tightens the risk premium across that space. And we should have better total returns also on the EMBI Global Diversified Index and the hard currency space. So that's my two cents on the election. It will be noisy, and it will be volatile until 5 November. We're just a bit less than four weeks away now from it. And if Trump wins, we're going to have some extra noise to the asset class, but it's probably an opportunity to add exposure. You know, we've been getting a more volatile environment since August, and historically since 1994, investors that used this volatility as opportunities to add exposure to an asset class they have been monitoring have done very, very well, in fact better than average within the next 12 months. So that's my view. I don't know if you have anything to add, Alexis?

Alexis de Mones: No, that covers it nicely.

Stephen Rudman: Thank both you, Gustavo and Alexis. Again, obviously very interesting times as we've had the dynamic with the changing rates and the US election, and so forth. With that, thanks to all that have attended. If there are any follow-up questions, please don't hesitate to reach out to your Ashmore representative. Obviously more than happy to get you further data, information, whatever would be helpful for your due diligence or your decision-making factors. Until the next time, as we say, be well.

Gustavo Medeiros: Thank you very much. Bye-bye.