JUL 2021

Outlook on Emerging Markets

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Equity In the second quarter, the MSCI Emerging Markets Index finished up 5.05% in US dollar terms. From a regional perspective, Latin America had a strong showing, driven by strong performance in Brazil, followed by Europe, the Middle East, & Africa (EMEA) and Asia. From a sector perspective, health care, energy, and industrials posted double-digit returns, followed by materials and financials securities, all of which outperformed the benchmark. Real estate, consumer discretionary, communication services, and information technology

lagged this quarter. While economically sensitive value securities, for which we use the MSCI Emerging Markets Value Index as a proxy, registered their third consecutive quarter of outperformance, growth securities (measured by the MSCI Emerging Markets Growth Index) posted strong gains in June.

In 2020, investors watched the COVID-19 pandemic materialize and spread around the world. A year later, the recovery is doing the same. The virus originated in China, and China was the first country to lock down and bring it under control, which allowed the country to also be the first to enter a recovery period. The United States now appears to be in the thick of the recovery period after a relatively successful vaccination campaign, and we expect that in retrospect, the second quarter will represent a peak in US GDP growth. After a slow start, Europe’s vaccination efforts are picking up, and we expect peak quarterly growth there in the third quarter of 2021.

In emerging markets, the pace of recovery has varied widely. China, Korea, and Taiwan all responded swiftly to control the initial outbreak and have been essentially open for several quarters now. (It’s worth noting that China has recently instituted lockdowns again to control outbreaks, and we feel breakthrough outbreaks will continue to happen.) However, India endured a brutal second wave that overwhelmed the country’s healthcare systems as recently as May 2021, and Latin America also continues to suffer mightily in some areas. Though vaccination rates have started to trend up in emerging markets, the rollout in the first half of the year was slower than we had expected or hoped. One of the reasons for that is that relatively little vaccine manufacturing occurs in emerging

Summary• The pace of recovery globally has varied widely, but with

vaccinations trending higher and a restart for global capital expenditures, we expect a stronger recovery in emerging markets in the second half of this year.

• The return of inflation is a good sign for economic growth, and therefore, good for emerging markets equities—particularly those with the highest levels of operating leverage. Our equities experts tend to think that core inflation will follow the path of developed markets inflation and push higher in the near term, but remain contained in the medium term.

• Overall, our outlook for emerging markets debt is constructive, and we believe the asset class is poised to deliver strong absolute and risk-adjusted returns.

• In the current environment, we believe being selective—among segments of the market and individual countries—will be key to capturing these returns. We see compelling value in three areas in particular: high yield hard currency sovereign debt, corporates, and increasingly, local currencies.

markets. We expect the countries included in the asset class to begin to recover in earnest in the second half of 2021 and continue into 2022, a more prolonged recovery than we would have suspected three months ago.

The virus isn’t the only factor playing a role in the emerging markets recovery. Rising commodity prices, buoyed in part by the global economic recovery, represent a tailwind for some exporting countries. Not only do rising prices bolster the performance of commodity-producing companies, they also help reduce fiscal and current account deficits in emerging markets economies. However, as we will discuss, the impact of rising prices is complex for emerging markets equities—not every emerging markets country benefits from an inflationary environment.

In terms of investing styles, value stocks, which tend to be in more cyclical sectors, have so far reaped the greatest rewards from the global reopening. The MSCI Emerging Markets Value Index returned 5.67% in the second quarter, outperforming the MSCI Emerging Markets Growth Index (+4.42%) for the third quarter in a row (Exhibit 1). Historically, market rotations from growth to value have been dramatically positive for value stocks. After more than a decade of underperforming growth stocks, we are hesitant to say just yet that a value rotation is in fact underway, but we are getting closer to that conclusion.

Corporations Reopen the Checkbook for CapexIt’s easy to write off the economic recovery in emerging markets as a result of rising commodity prices, as most emerging markets countries are net exporters of commodities, or of favorable base effects in comparing growth to a year ago, in the thick of a pandemic. However, with the expectation of an economic rebound, new infrastructure programs, and an increasing focus on environmental sustainability, capital expenditures could increase, particularly in the developed world. In their role as suppliers to the developed world, an uptick in capital spending in developed markets bodes well for emerging markets. In the United States, capital spending is increasing by 15%1 year over year, as companies spend on both durable goods (e.g., machines and factories) and intangibles (e.g., software).

Forecasts for gross fixed capital formation are projected to be much higher in 2021 than in 2020 in both the developed and emerging world. The United States and euro area are expected to reach 8.0% and 5.7% this year, respectively, and the figures vary widely across emerging markets: Colombia, Argentina, and India are expecting 16% to 21% gains; Hungary, Indonesia, Brazil, Chile, and Greece range from 8% to 12%; South Africa, Korea, Mexico, Turkey, and Russia have the lowest gains, from 1% to 7%; while fixed capital formation will actually decline in Poland and the Czech Republic (Exhibit 2).

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Exhibit 2Most Countries Will See Capex Rise in 2021

Gross Fixed Capital Formation (YoY, %)-30 -20 -10 0 10 20 30

2020

Colombia

Poland -3.3-2.4Czech Republic

South Africa 1.6

Mexico 3.5

Korea 3.6

Turkey 5.6

Euro 5.7

OECD 5.9

Russia 6.6

US 8.0

Hungary 8.3

Indonesia 8.4

Brazil 8.6

Chile 9.3

Greece 11.5

India 16.3Argentina 18.2

20.6

-30 -20 -10 0 10 20 30

Poland -9.6

Czech Republic -8.1

South Africa -17.5

Mexico -18.2

Korea 2.8

Turkey 6.5

Euro -8.5

OECD -4.4

Russia -4.3

US -0.8

Hungary -7.3

Indonesia -4.9

Brazil -0.6

Chile -11.8

Greece -0.7

India -14.0

Argentina -13.0Colombia -20.6

2021

As of 31 May 2021

Source: Haver Analytics, OECD

Exhibit 1The Value Proposition

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Jun 2021

May 2021

Apr 2021

Mar 2021

Feb 2021

Jan 2021

Dec 2020

Nov 2020

Oct 2020

Index (100 = 30 September 2020)

MSCI EM Value [LHS]

MSCI EM Growth [LHS]

Value Relative to Growth [RHS]

As of 30 June 2021

Source: MSCI

From an industry perspective, global technology firms are leading the capital spending charge. Apple is expected to invest $430 billion in the United States over a five-year period. Taiwan Semiconductor Manufacturing Company, the world’s largest semiconductor-maker, recently announced that it would invest $100 billion over the next three years to expand and upgrade its chip capacity. After having already increased its capital spending by 45% in 2020, Samsung Electronics is expected to bump up its spending plans this year. Additionally, capital spending is expected to be higher for Korean shipbuilders, particularly for the development of eco-friendly vessels and expansion of low-carbon production facilities to meet stricter environmental regulations.

Not all firms are increasing spending plans, however. For instance, many oil and gas and raw materials companies continue to practice capital discipline, even as commodity prices have moved significantly higher.

On the government side, plans for large-scale infrastructure investment in the US and Europe are likely to be a major catalyst for global economic growth, particularly in developed markets. It is still unclear exactly what the scope of an infrastructure might be in the United States, as Republicans and Democrats disagree on what the priorities should be. But what does seem fairly safe to assume is that a major spending bill that provides for upgrades to roads and bridges, public transit, water and wastewater systems, and other traditional infrastructure will pass in the coming months. If US President Joseph Biden is successful in achieving his priorities, there could also be added spending on a broader definition of infrastructure projects, including electric vehicle production and basic research. In the European Union, the €570 billion Next Generation EU Project is gearing up to fund a slew of infrastructure projects that vary by country, but include many projects focused on sustainability and environmental objectives. This project should in particular benefit the three Central European economies in the MSCI EM Index (Czech Republic, Hungary, and Poland).

Aside from boosting overall economic growth, the spending in developed markets should feed through to emerging markets mostly in the form of higher demand for raw materials such as steel, copper, and cement. HSBC noted in a recent report that developed economies tend to use more recycled materials and perform repairs and upgrades, which provide less of a boost to commodities than starting from scratch with new materials, which tends to occur in emerging markets. However, both plans have a much greater focus on environmental priorities than in the past, which could bode well for minerals associated with the batteries that store solar and wind power, as well as those that power electric vehicles, including cobalt and lithium, as well as the copper in the wiring that conducts the electricity. It’s also worth noting that climate negotiations begin again in November, and demand for green infrastructure should remain strong as countries strive to make progress toward their emissions reductions pledges. All in all, we believe infrastructure plans could provide a meaningful boost to demand for raw materials, which would be a boon to emerging markets equities.

The uptick in capital investment is particularly good for growth-sensitive assets, as well as assets that benefit from higher commodities prices. Though investment fell sharply at the start of the COVID-19 pandemic, it has bounced back relatively quickly. The hope

for equities investors is that the nascent pick-up in global capital spending persists long after most economies reopen, allowing for faster global economic growth and higher productivity in this recovery than the sluggish pace set in the years that followed the global financial crisis. Given the position many emerging markets companies hold in the global supply chain, a pick-up in capital spending around the world is a very good signal for emerging markets equities overall, particularly growth-sensitive stocks, names that benefit from higher commodities prices, and those that produce goods, rather than services.

Inflation: Here to Stay or Soon on Its Way? Inflation has returned to the global economy. The United States has experienced perhaps the most dramatic uptick in prices, with headline consumer prices rising 5% for the 12 months ending in May and the core inflation rate reaching 3.8%, the highest level since 1992. In emerging markets, inflation is also trending up, pushed by a combination of pandemic-related uncertainty, supply bottlenecks and logistical issues, and higher energy prices. Meanwhile, producer prices are soaring in emerging markets, but so far, the feed-through to consumer prices has been uneven (Exhibit 3).

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Exhibit 3Input Costs Are Soaring, but the Story Is More Complicated for Consumer Prices

Producer Prices Moving Higher across EM

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Mar ΄21Sep ΄20Mar ΄20Sep ΄19Mar ΄19Sep ΄18Mar΄18

PPI (YoY, %)

Mexico RussiaIndiaChinaChileBrazil

Consumer Prices Remain Wide-Ranging

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May ΄21Nov ΄20May ΄20Nov ΄19May ΄19Nov ΄18May ΄18

CPI (YoY, %)

Mexico EMIndonesia Russia

IndiaChina

ChileBrazil

PPI data as of 31 May 2021 and 30 April for Brazil; CPI data as of 31 May and 30 April for EM only

Source: Biro Pusat Statistik (Indonesia), Federal State Statistics Service (Russia), Haver Analytics, Instituto Brasileiro de Geografia e Estatística (Brazil), Instituto Nacional de Estadísticas (Chile), Instituto Nacional de Estadística Geografía e Informática (Mexico), Ministry of Commerce and Industry (India), Ministry of Statistics and Programme Implementation (India), National Bureau of Statistics of China

China is a good example of the forces at work. The producer price index (PPI) rose 6.8% year over year in April and 9.0% in May, the fastest pace in more than three years, thanks largely to a rebound in commodities prices. Brent crude oil is nearing US$75 per barrel and futures prices for iron ore, the main ingredient for making steel, surged to almost US$230 a tonne in May, the highest level on record. The rapid recovery in the Chinese economy has driven strong demand for raw materials, including a construction boom that led to record steel production of 1.1 billion tonnes in 2020. Chinese policy leaders pledged to release government stockpiles of industrial metals to address both the high prices and a shortage of iron ore. They have also launched a review into “malicious speculation” in iron ore markets.

The intervention, plus the Federal Reserve’s somewhat hawkish comments in June, pushed commodity prices lower, but even before that, it was unclear to what degree rising commodity prices would ultimately trickle down to the consumer. China’s consumer price index (CPI) rose 0.9% in April and 1.5% in May, the highest level in eight months, but was still well below the country’s 3% target. However, a shortage of semiconductors has already begun to drive up price increases for various consumer products, such as washing machines and laptops (Exhibit 4).

The return of inflation is pushing a growing number of emerging markets central banks to abandon the dovish policies of the COVID-19 era and begin tightening monetary policy. In fact, the steady announcements are reminiscent of the synchronized easing that took place during the pandemic.

• The Central Bank of Brazil hiked rates 75 basis points (bps) three times over the last three months and at its most recent meeting in June indicated that it would likely raise rates another 75 bps at its next meeting, which would put interest rates at 5%. The central bank has said that if inflation expectations go much higher, they could hike all the way to the neutral rate, which is about 6.25%.2

• Russia’s central bank raised its policy interest rate for the second consecutive time in June to tame inflation, which is running at its highest level in almost five years. The CPI rose to 6% last month, well above the 4% inflation target and driven by a

sharp rise in global food and commodity prices. Price caps have been implemented by some of Russia’s top retailers on some key consumer staples, and the economy minister is considering implementing export quotas or additional duties on food products should global prices continue to push higher.

• Hungary became the first European nation to hike rates in June, followed quickly by the Czech Republic. Though Hungary’s actual increase was relatively small (0.3% to 0.9%), it was significant. It was the first time the central bank had raised interest rates in 10 years, and officials explicitly noted that it was the beginning of a hiking cycle that would end only when the country’s inflation rate, the highest in Europe, reached a “sustainable level.”

• Banxico surprised investors with a rate hike in late June, immediately touching off speculation about whether the increase was a one-off response to a higher-than-expected inflation print or the beginning of a hiking cycle.

We feel that the uptick in inflation, a signal of strong economic growth, is generally a good thing for equities, especially in emerging markets. The earnings outlook is particularly strong for companies with the highest operating leverage, or those that stand to earn greater profits as sales increase. Both prices and input costs rise in an inflationary environment, but a high proportion of costs are fixed for a company with high operating leverage, putting them in a better position to maintain or increase profit levels as their revenues climb.

However, rising prices are not an unmitigated good. Our biggest concern would be if inflation reaches a level so high that it impedes global growth, which would be a clear negative for emerging markets equities. Certain segments of the asset class are likely to feel pain even in a less extreme inflationary environment. Reflation—which occurs when prices rise because an economy is getting back to normal—can lead to derating or contracting equity valuation multiples for companies in certain rate-sensitive sectors. Growth stocks with extremely elevated valuation multiples are often more vulnerable to this kind of negative market reaction, particularly those in the healthcare, communication services, consumer discretionary, and information technology sectors. That’s because much of their earnings potential lies in the future, and higher interest rates reduce the current value of those earnings.

All in all, we believe the best scenario would be one in which inflation rises gradually to a level higher than what investors have become accustomed to over the last 13 years, but fails to reach a level in developed markets that holds back economic growth. Since the global financial crisis, both economic growth and price increases have been anemic, the latter a likely result of prolonged quantitative easing and ultra-easy monetary policy. An environment of little-to-no inflation, or even falling prices for certain commodities and other goods, has been damaging for emerging markets, just as a hyperinflationary environment would be.

As we weigh the pros and cons of the return of inflation, we also weigh arguments that the current environment will prove fleeting against those that it will endure. Those who believe inflation will soon fade argue that it is a temporary artifact of the world coming back online. During the pandemic, lockdowns and quarantine rules shuttered or disrupted manufacturing in many areas; demand for certain goods, particularly those that could be used in a new home-

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Exhibit 4China’s Rising Producer Prices Start to Feed into Consumer Costs

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2021202020192018201720162015201420132012

(%)

PPI

CPI

As of 31 May 2021

Source: National Bureau of Statistics of China

centered lifestyle, such as exercise equipment or computers, rose; and shipping demand overwhelmed ports and logistics companies, many of which were also grappling with new pandemic safety measures that decreased capacity. All of these things contributed to higher prices, particularly on certain items.

Rising food prices are a major concern in emerging markets economies. Global food prices have increased by the largest margin in a decade, with the United Nations Food and Agriculture Organization (UN FAO) Food Price Index rising 40% in May (Exhibit 5). The higher inflation will disproportionately impact poorer countries that rely on imports for staple goods. The cost of labor, transport, and shipping will continue to pressure food prices in the coming months. Rising food commodity prices reflect China’s large demand for grain and soybeans; a severe drought in Brazil, which is a leading corn and soybean exporter; and increased demand for vegetable oil for biodiesel.

However, as lockdowns become less frequent and economies reopen, bottlenecks on making and moving goods should ease, too. In addition, many companies seem to have learned valuable lessons from COVID-19 and reported plans to bolster their supply chains for the future. Nearly 40% of large US companies surveyed recently by EY said they had plans to make their supply chains more resilient in the coming year, with nearly 20% saying they would diversify their suppliers.

We believe it is too early to pick a side in the debate about the staying power of recent inflation. The temporary effect of reopening is hard to parse out of the current numbers, and year-over-year prints still compare today’s prices to a very low base from a more dire period in the pandemic’s history. We tend to think that core inflation will follow the path of developed markets inflation and push higher in the near term, but remain contained in the medium term. Shocks to current inflation drivers, including food and energy prices and output gaps, are expected to be short-lived—an artifact of post-pandemic readjustment. More importantly, we believe that pent-up demand, help from government stimulus, and renewed capital expenditures all support a multi-year period of high global growth. Should that come to pass, it would be a very positive development for emerging markets stocks, particularly since we think it is highly unlikely emerging markets central banks will tighten aggressively.

Latin American Politics SimmersOf the three major emerging markets regions, Latin America suffered by far the worst human and economic toll from COVID-19. It is not surprising, then, that a year after the pandemic reached the region, a number of critically important political changes occurred in Latin America in the second quarter. Mass protests broke out in Colombia in April over a proposed tax increase, but even though the proposal was scrapped, demonstrations have continued for about two months, apparently fueled by anger over economic inequality. Meanwhile, surprise election results in Peru and Mexico have reshaped the political landscape.

Peru has had arguably the most dramatic political landscape in the world over the past two years. Within a week in November 2020, the country churned through three presidents. On 5 June, the country elected its fourth president in a year, leftist Pedro Castillo. The result was still not official as of 18 June, with Castillo’s opponent, Keiko Fujimori, claiming that election irregularities had tainted the process and the result. However, it seems likely that Castillo will become the next president.

On the campaign trail, Castillo discussed plans to increase social spending, raise taxes significantly on the mining sector, and possibly even nationalize key industries. As the world’s second-largest copper producer, any developments related to the mining sector and private participation in it would be critical not only for Peru, but for the world. However, Castillo and his economic advisors have been reassuring markets that they do not plan to make radical changes, talking down the risk of nationalization, and vowing to protect both property rights and monetary policy independence. Another reason to be optimistic about radical changes is that the Congress is divided, with right-leaning parties controlling a clear majority of the votes. While Castillo has yet to announce what he will actually do in office, we will certainly be keeping a close eye on developments in the country.

The mood of the electorate seemed to go the opposite way in Mexico, where the left-leaning coalition led by President Andrés Manuel López Obrador lost its supermajority in the lower house in the midterm elections. With a simple majority in both the Senate and Chamber of Deputies, the President’s ruling MORENA Party will still be able to approve some new laws and proposals. López Obrador can also ask the public to vote on specific issues to demonstrate to his opponents that he maintains strong public support. As with a 2018 referendum to cancel the Mexico City airport, these referendums would be non-binding.

The outcome means that López Obrador is likely to encounter stronger checks on his power from parliament going forward, thereby reducing his chances of passing constitutional reforms to further his nationalist agenda, most notably in the energy sector. The prior administration had awarded a number of permits to private-sector companies to break up the state’s monopoly hold on power generation in the country and revitalize Mexico’s power infrastructure, but López Obrador had held up the permits and hoped to stop the privatization bid entirely. López Obrador also had plans to reform the country’s hydrocarbon law to give Pemex, the state-owned oil company, more control over the domestic oil market. Previous administrations had opened Mexico’s oil industry up to private investment, but the

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Exhibit 5Skyrocketing Food Prices Can Be Devastating for Poor EM Countries

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20212020201920182017201620152014201320122011

UN FAO Food Price Index (YoY, %)

As of 31 May 2021

Source: UN FAO

reforms López Obrador wanted to pass would give Pemex the right to suspend their permits and take over their facilities if there was a threat to security or the economy.

The drop in popular support for MORENA suggests that the president’s star may be waning three years after winning a landslide election, which in turn increases the potential for fragmentation among the governing coalition. We see this as a positive development, as it has the potential to strengthen political checks and balances, reduce policy uncertainty, and improve the investment outlook.

Meanwhile, good news about the progress of the pandemic finally started to trickle out of Brazil, Latin America’s largest economy and one of the hardest-hit by COVID-19. Vaccination efforts are finally gathering steam: 27% of adults have at least one shot, while 11% are fully vaccinated. While the Chinese CoronaVac vaccine accounts for roughly half of the 80 million jabs already administered in the country, most future vaccinations will be with mRNA and viral vector vaccines. In the first quarter, before vaccinations ramped up in earnest, GDP growth returned to pre-pandemic levels of 1.2%, so it seems reasonable that second-quarter results could be even stronger. As the vaccine rollout accelerates, we expect an improved recovery picture in Brazil by the end of the year.

On the political front, President Jair Bolsonaro’s approval ratings have stabilized and could improve as the national vaccine rollout advances in the coming months and economic recovery gets underway in earnest in the coming quarters. Next year’s presidential election between Bolsonaro and former President Luiz Inácio Lula da Silva looks to be a very polarizing and competitive election.

DebtEmerging Markets Are Retaking the LeadEmerging markets debt enjoyed smoother sailing in the second quarter. US Treasury bond volatility declined, and the US dollar weakened, allowing the blended hard and local currency emerging markets debt asset class to earn a solid gain of around 4%. The asset class almost fully retraced its loss from the first quarter, when it was caught in a tug of war between the positive effect of better global growth expectations and the negative effect of rising US interest rates, with the latter winning out.

Although volatility picked up in the final weeks of the second quarter as the Fed adopted a more hawkish tone, we see the pullback as transitory and the factors driving our constructive outlook remain intact. It is not often that top-down factors, bottom-up fundamentals, and valuations align favorably, and we believe the asset class is poised to generate attractive returns, both on an absolute basis and relative to other fixed income sectors.

Accelerating GrowthFirst and foremost, the macro backdrop for emerging markets debt is increasingly favorable. Emerging markets assets are levered to global growth; specifically, growth differentials between the emerging and developed worlds tend to be key performance drivers for the most cyclically sensitive emerging markets assets, such as local currencies.

Emerging markets growth has lagged potential and developed markets for much of the last decade and is expected to do so in 2021 as well. The United States is projected to grow 6.5%–7.0% in 2021, the highest rate in decades, thanks to extraordinary fiscal stimulus and a swift COVID-19 vaccine rollout, taking growth preeminence among all major economies except China.

Now, however, this backdrop is starting to turn: Emerging markets growth is beginning to accelerate just as developed markets growth expectations are starting to decelerate from abnormally high levels. In fact, emerging markets growth is expected to take the lead in the fourth quarter and continue leading in 2022, as the influence of the developed world’s vast stimulus and swift vaccine rollout fade and base comparisons become more difficult (Exhibit 6). Emerging markets growth is already building steam thanks to strong external demand and elevated commodity prices. Going forward, the factors that have caused emerging markets growth to lag in 2021—struggles in containing COVID-19 and delayed vaccine rollouts—are likely to reverse. When that happens, we expect a further boost in growth from pent-up demand as economies can more fully reopen.

We are encouraged by the trend of upward revisions to emerging markets growth forecasts. The OECD now expects emerging markets growth to be 4.5% above its pre-COVID level by the fourth quarter, up from 1.6% in the December forecast (Exhibit 7). We think such upward revisions will continue as the cyclical recovery takes hold and emerging markets countries outperform low expectations. For example, Brazil has struggled to control COVID-19, and political turmoil has further weighed on the economy. However, the economic data already show signs of improvement. First-quarter growth came in at 1.2%, which was 0.7% above the consensus expectation. More importantly, the outlook continues to improve. Prior to the first quarter upside surprise, consensus expectations for 2021 had already been revised upwards from 3% to 4%, and we think the Brazilian economy could grow even faster if the country manages to accelerate the pace of vaccinations. So far in June, Brazil has deployed an average 1 million shots per day, according to data compiled by Bloomberg—a sharp increase from the 663,000 seen in May.

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Exhibit 6Growth Differentials Are Shifting in Favor of Emerging Markets

GDP Forecasts (Seasonally Adjusted Annual Rate)

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2Q221Q224Q213Q212Q21

(QoQ, %)

Emerging MarketsDeveloped Markets

As of 10 June 2021

Source: JPMorgan

The markets oscillated during the final weeks of the second quarter as investors grappled with a shift in tone at the Fed. In our view, the Fed will only begin to tighten policy once the economy shows evidence of a sustained recovery and even then, will do so at a gradual pace. The Fed has yet to even discuss the timing of tapering its $120 billion per month bond purchase program, and the actual implementation is unlikely before 2022. The fact is that financial conditions are highly accommodative and are likely to remain so, with the rate-hike cycle unlikely to kick off before 2023. In fact, financial conditions in the United States are the easiest on record (Exhibit 8). We are watching for any signs of tightening financial conditions, which would likely have negative implications for demand in risk assets, including emerging markets debt.

Resilient FundamentalsWhile the global backdrop is always a key consideration in the emerging markets debt outlook, bottom-up fundamentals must not be overlooked. The pandemic took a toll on emerging markets—both socially and economically. In 2020, sovereign debt-to-GDP ratios

rose, and fiscal balances deteriorated. However, signs of recovery are showing. Debt-to-GDP ratios are manageable, especially given the favorable funding mix, and are now expected to decline (Exhibit 9) thanks to improved growth, and access to capital through a healthy new issue market, IMF lending programs, and debt sustainability initiatives. Meanwhile, fiscal balances are set to improve due to higher growth, prudent policy measures, and lower expenditures as pandemic-related spending declines. For commodity exporters, improving terms of trade should serve as an additional tailwind. Although commodity prices have come off recent highs of late, they remain elevated. Additionally, current accounts are also nearly balanced on the whole, and many countries are accumulating foreign reserves as an additional buffer.

Emerging markets corporate fundamentals have been remarkably resilient, and we think their improvement in credit metrics will continue. Net leverage deteriorated only slightly in 2020, whereas US and European corporates generally saw leverage ratios increase around 1.5x (Exhibit 10). Looking ahead, emerging markets corporates should benefit from the robust rebound in global growth

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Exhibit 7OECD Emerging Markets GDP Forecasts Revised Higher

GDP vs. Pre-COVID Levels

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2022-Q42022-Q22021-Q42021-Q22020-Q42020-Q22019-Q4

GDP Forecast (Index, 100=Q4 2019)

December 2020 Forecast

Current Forecast

As of 1 June 2021

Source: OECD

Exhibit 8Financial Conditions Remain Highly Accommodative

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Goldman Sachs US Financial Conditions Index (Inverted)

As of 18 June 2021

Source: Goldman Sachs

Exhibit 9EM Sovereign Debt Ratios Are Manageable and Likely to Decline

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2́1F2́01́91́81́71́61́51́41́31́21́11́00́90́80́70́60́50́40́30́20́10́00

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36

48

60($T) (%)

Local Debt [LHS]External Debt [LHS] Debt/GDP [RHS]

As of 31 May 2021

Source: Lazard, Haver Analytics, JPMorgan

Exhibit 10EM Corporate High Yield Leverage Is 2x–3x Lower than DM

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202020192018201720162015

Net Leverage (x)

European HYUS HYGlobal EM HY

As of 31 May 2021

Source: Lazard, JPMorgan

and strong commodity prices as global demand recovers. On a bottom-up basis, we expect leverage to decline in 2021 toward pre-pandemic levels and remain well below levels of developed markets peers, reflecting conservative corporate behavior and the focus on deleveraging in emerging markets in recent years. By and large, emerging markets corporates have used the low interest rate environment and healthy investor demand over the past few years to refinance existing debt at attractive levels. Additionally, companies generally have ample liquidity and limited funding needs.

Attractive Valuations in SegmentsWhile the macroeconomic outlook and bottom-up fundamentals are aligned in favor of the asset class, it is always important to view the opportunity through a valuation lens. Valuations are not uniformly attractive across the asset class, and thus, we believe it is important for investors to be highly selective in this environment. We see compelling value in three areas in particular: high yield hard currency sovereign debt, corporates, and increasingly, local currencies.

Spreads in high yield sovereign credit remain elevated, especially compared to investment grade, and are not fully reflective of the improving environment. High yield spreads are currently around 570 bps, which is approximately 80 bps wide of pre-pandemic levels (Exhibit 11). While spreads are unlikely to compress beyond pre-pandemic levels, we see scope for 25–50 bps of further tightening in high yield sovereigns. In contrast, investment grade spreads have been hovering near historical lows of around 150 bps and offer very little potential for further tightening, although steep yield curves in select markets offer attractive carry opportunities.

After handily outperforming sovereign credit and local currency debt in 2020, emerging markets corporates continued to lead the pack in the second quarter and are the only segment of the asset class to deliver a positive return thus far in 2021. We expect this resilience in corporates to continue. While rising interest rates pose a risk to fixed income returns, emerging markets corporates offer a degree

of protection given their higher spreads and shorter durations in general. Moreover, emerging markets corporates offer a considerable spread pick-up over developed markets corporates (Exhibit 12), despite their current stronger fundamentals. We expect modest spread tightening to continue over the remainder of 2021 and view corporates as a structurally attractive source of yield.

The final area where we see attractive valuations is in local currencies. Our outlook for emerging markets currencies continues to improve and is highly constructive over the medium term for several reasons. We believe the US dollar is likely to weaken due to the broadening of the global recovery, highly accommodative Fed policy, and growing US twin deficits. Also, central banks in many emerging markets have recently begun to normalize policy rates, and the widening of interest rate differentials within developed markets should further support local currencies. While emerging markets currencies have lagged other asset classes, particularly commodities (Exhibit 13), which tend to be highly correlated to global growth, we expect them to catch up meaningfully.

8

Exhibit 11Difference between High Yield and Investment Grade Sovereign Spreads Remains Elevated

0

200

400

600

800

1,000

2021202020192018201720160

300

600

900

1,200

1,500

(bps) (bps)

HY-IG Spread [RHS]Investment Grade Spread [LHS] High Yield Spread [LHS]

As of 21 June 2021

Source: Lazard, JPMorgan

Exhibit 12EM Corporate Bonds Offer an Attractive Spread Pick-Up vs. US Corporates

-100

0

100

200

300

20212020201920182017201620152014201320122011

Spread (EM-DM, bps)

High YieldInvestment Grade

As of 13 July 2021

Source: Lazard, Barclays, Bloomberg, JPMorgan

Exhibit 13EM Currency Has Lagged the Rebound in Commodities

0.9

1.0

1.1

1.2

1.3

1.4

1.5

20212019201720152013201120092007200520030.5

1.0

1.5

2.0

2.5

3.0

3.5

EFMX REER [LHS](Index, 1=31 October 2000)

Commodities [RHS](Index, 1 = 31 October 2000)

EMFX REER [LHS]Commodities [RHS]

As of 31 May 2021

Source: Lazard, JPMorgan

Outlook on Emerging Markets

In the shorter term, however, we are taking a more cautious approach and have not yet begun to meaningfully add risk due to lingering uncertainty about the US fiscal and monetary policy mix. The Fed’s decision on when to begin tapering its asset purchases is likely of particular relevance in the near term but shouldn’t meaningfully impact the medium-term outlook for currencies.

Overall, our outlook for emerging markets debt is improving, and we believe the asset class is poised to deliver strong absolute and risk-adjusted returns. In the current environment, we believe being selective—among segments of the market and individual countries—will be key to capturing these returns.

This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm.

Notes1 The Economist, 25 May 2021. “An Investment Bonanza is Coming.”

2 Source https://www.reuters.com/world/americas/brazil-central-bank-hikes-interest-rates-eyes-return-neutral-rate-2021-06-16/

Important InformationOriginally published on 7 July 2021. Revised and republished on 16 July 2021.This document reflects the views of Lazard Asset Management LLC or its affiliates (“Lazard”) based upon information believed to be reliable as of the publication date. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates (“Lazard”) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service, or investment product. Investments in securities, derivatives, and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard’s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard’s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past perfor-mance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard’s local regulatory authorizations. Please visit www.lazardassetmanagement.com/globaldisclosure for the specific Lazard entities that have issued this document and the scope of their authorized activities.