Rising interest rates have helped to boost the appeal of bond markets. Hafiz Noordin, Portfolio Manager, Global Fixed Income at TD Asset Management, tells Greg Bonnell, those looking to diversify their holdings even further might find opportunities in emerging markets.
- Rising interest rates have made the bond market a little more interesting for the first time in years. And our featured guest today says if you're looking to diversify your holdings, there's good opportunity in the emerging markets. Joining us now is Hafiz Noordin, portfolio manager for global fixed income at TD Asset Management. Great to have you with us on the program.
A lot of people-- we're getting questions every show, whether it's about fixed income or not, about fixed income. Tell me about what you're seeing in the emerging markets.
- Well, it's great to be here first of all, Greg. And it's definitely been a tough environment for emerging markets. We're seeing rising global inflation, as a result of rising global interest rates, and on top of it now, we're seeing a period of time where growth will likely slow down a bit here.
And so, historically, that's been a tough environment. But what we're seeing now is that there's a number of winners and losers in the emerging world. There are some that are more impacted by Russia's invasion of Ukraine. But on the other side, there's a number of nations that have been proactive in raising rates and their central banks raising rates well ahead of what the Federal Reserve and the Bank of Canada have been doing.
And add to that, some of those countries are also commodity exporters. So they've been really linked to this cycle that we've seen in rising commodity prices and have actually benefited, and those have provided interesting opportunities to enhance yield in a fixed income portfolio.
- All right, so that's our prediction to the opportunities in the emerging markets. Of course, as we go through the emerging markets, it's not just one group with all the same characteristics. Take us a little deeper into some of the different pockets that you're seeing.
- For sure. Well, I think it's nice to take a regional approach. Latin America I think is really-- it was one of those regions where commodity exports have been really helping in terms of boosting fiscal revenues and providing more stability in their currencies. But on the other end of that spectrum, there's a number of commodity importers that have been losing out-- India, a lot of Asian countries, some of the Eastern European countries. When they're importing commodities, that really has caused a lot more strain on their fiscal balances. And that's just caused inflation to rise further. So I think that's one differentiator is commodities.
But the other is how ahead or behind the curve are some of these countries in raising rates. Some that have been behind the curve, such as in Eastern Europe going into this year, had a lot more pain. Their bonds are down about 40% this year just because of having to now really catch up in hiking rates, and then on top of it, the sentiment around Russia's invasion of Ukraine. So I think it's the commodity links and then how good the central banks are doing in terms of hiking rates in the face of inflation.
- Yeah, we talk so much about the Fed, obviously, because the whole world is watching the US Federal Reserve, the world's most powerful central bank. Here at home, we talk about the Bank of Canada. It's interesting that you mention the fact that perhaps there's some central banks in these emerging markets that have been a little more proactive than we have been.
- That's right. And I think what happens in some emerging markets, and Mexico and Brazil are probably good examples where they saw inflation rising quickly last year-- they know from past cycles that they have to get ahead of this. Otherwise, their currencies can get out of control because crises happen a lot in emerging markets.
And so what they did on average in Latin America-- on average, about 650 basis points of hiking has occurred between the beginning of 2021 and now. And that compares to the Fed and Bank of Canada where it's been about 100, 150 basis points of hikes over the last few months only. And so because they did that, a lot more foreign capital entered the country, comfortable that their yields were high enough to buffer inflation a little bit. And as a result, they were able to benefit from those capital inflows and keep their economies a little bit more stable.
- So we talked about emerging markets. We talked about the fixed income opportunities. Are we almost on the cusp of calling it high yield, or would that be going a little too far?
- Well, there's actually a distinction. There's definitely some solid investment-grade emerging market names, some single A rated, like China or Chile or Peru, which have very low debt levels and historically have very good management teams. Their governments have been doing a good job of managing their fiscal balances.
And then there's some kind of in the DDD area. So I'd say like a Mexico or Indonesia, which are pretty solid investment-grade names. Their credit quality is pretty good. But there are some more risks that you have to watch to make sure they aren't going to get downgraded to high yield. But in the meantime, you're getting compensated for those risks.
And then there's definitely the high yield names which can get a lot more risky. If you do the bottom-up research right, then there's good opportunities. But there's definitely some names there where things can get out of hand fairly quickly without the right government in place. And they can get into defaults situation.
So similar to the corporate market, you do have to do that bottom-up research. I really don't think emerging markets are a passive investment. A lot of indices in emerging markets tend to allocate capital to the largest borrowers, which is probably not the rule you want to be using when you have that kind of differentiation in credit quality.
- All right, I got a feeling our audience is probably intrigued. So let's talk about that, doing your homework, that process of assessing different emerging markets. What are the screens you sort of put in place?
- Well, it certainly starts with a sense of macrostability. And what I mean by that is that, are there rules in place to manage fiscal balances. Emerging markets do have the benefit of being high-growth countries because their populations are growing more rapidly. There's more gains to be had from productivity improvements. But usually, the trap they fall into is mismanaging their fiscal balances.
Some countries have debt to GDP levels of 80% to 90%, which is very high, even higher than some developed markets. And that's where you have to be careful that, if they're getting to those high debt levels, are they putting in place rules, fiscal spending caps, for instance, to make sure that that doesn't go too much higher?
The other area that we look at are reserves. When there's a lot of currency volatility as we're seeing right now, you need to make sure that emerging markets that are borrowing in US dollars, are borrowing in Euro, have the necessary currency reserves to help to meet some of those external liabilities. So really understanding the data and also how well the governments are doing in managing those balances and not spending them on non-productive measures.
- Yeah, I wanted to ask you when you brought up the US currency reserves how they're managing that, because, obviously, the reason why the entire world looks to the US Federal Reserve is just because of the influence they have. What if the Fed has to stay on this aggressive path? What does that start doing to the emerging market opportunities?
- Well, I think that's a great point because that's really the key risk right now. The market for now has priced in the rate hikes that we're seeing that the Fed will have to get to above a neutral area. So call it a 3 and 1/2% to 4% area on their policy rate. And so emerging markets for now have kind of priced that in, but the risk is that it accelerates higher if inflation continues to surprise to the upside.
And I think what that will cause is that, for those emerging markets that don't have sufficient reserves, they will start to see more expensive US dollar debt that they have to start to pay back. Turkey is a very good example where they have very low reserves, and they have very unorthodox monetary policy, and they tend to get into trouble in times like this and already have been getting into trouble with the US dollar starting to go up and with US bond yields going up.
The flip side, there's some countries like Brazil, I'd highlight, that have very strong reserves. Yes, their debt levels are high, but they have so much reserves that they've gained from commodity exports over the years that they can likely buffer some of those shocks from higher US interest rates.
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