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Fixed income

Emerging markets debt perspectives: Adapting to China’s shifting (and slowing) winds

Aaron Enriquez
Senior Research Analyst
Chungwei Hsia
Senior Research Analyst
John Espinosa
Head of Sovereigns, Portfolio Manager
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Bottom line up front (BLUF):

EMD performance review

EMD performance faltered in the third quarter as a rates-driven sell-off took hold amid growing risk-off sentiment and sticky inflationary pressures. The USD reversed recent losses and gained against most emerging- and developed-market currencies. Stronger than expected U.S. growth and a hawkish hold from the Fed in September drove U.S. rates higher. For the full quarter, all EMD segments declined, with local markets underperforming sovereigns and corporates. Much of the decline in sovereigns was driven by rates as longer-duration, higher-quality declined. Local debt was driven primarily by currency (FX) declines (-2.6%) with rates also detracting (-0.7%). In the geopolitical arena, Chinese authorities continued to slowly drip stimulus measures to help shore up confidence in their growth outlook and credit fundamentals. The Ukrainians have made some very modest incremental gains by piercing Russia’s defense line in the occupied south. Ecuadorians went to the polls in August for general elections as incumbent Guillermo Lasso choose not to seek reelection. Advancing to the October runoff are Luisa Gonzalez, who won the highest percentage and, unexpectedly, Daniel Noboa who gathered the second most votes.

We’re not in Henan (Kansas) anymore

While analyzing the Chinese economy has always been difficult, over the past decade and a half market participants could rely on the government’s annual target being met. Under President Xi, a rebalancing has occurred – prioritizing security and self-sufficiency over economic growth. Amid structural issues such as rising leverage, falling potential growth, geopolitical tensions, and more centralized decision making – we’ve seen more unpredictable policymaking while the reaction function has slowed.  Unexpected crackdowns on the property, private education, technology, gaming, financials, and healthcare sectors, on top of the years’ long Zero-Covid policy, amplified headwinds on the private sector. As a result, we think the potential growth has decelerated faster than previously thought. Since then, we’ve have had to constantly re-evaluate and tweak our views on how China directly and indirectly impacts to our portfolios.

 
Avoiding the debt doldrums

Chinese sovereign bonds boast a strong credit rating (A1/A+) and benefit from supply/demand dynamics for both USD and local currency government bonds – thus keeping volatility low. However, valuations are unattractive with yields below U.S. treasuries. We do believe, however, that there is scope for longer duration local currency treasuries to perform due to very high domestic savings and falling potential growth. On the currency, we think RMB (Renminbi) will continue to trade weak against the USD in the near term (given interest rate differentials) but broadly stable vs other currencies (still high current account surplus). The central bank still has more than sufficient tools (e.g., >$4 trillion FX reserves) and incentive to limit excess depreciation pressure.

We’ve long been cautious on the USD corporate bond market, maintaining an underweight due to valuations and concerns around transparency, overcapacity, structural subordination, and an undeveloped bankruptcy regime. Major state-owned enterprises (SOEs) have relatively healthy balance sheets and benefit from strong state support, however rising geopolitical tensions make us wary of sanctions. Traditionally, we have treaded very cautiously in the property sector but hold modest positions in select mandates, primarily due to the sector’s index weight and high relative yields. We have stayed in the larger, more liquid developers but, given the extent and duration of the property crackdown on top of weakening structural trends, we continue to monitor these positions very closely.

One sector we maintain exposure to is the Macau gaming space. The space has been battered by COVID lockdowns and license renewals from regulators but pre-emptive financing, strong parental support, eventual reopening, and improving mix/profitability led the sector to bounce back strongly with earnings having potential to exceed pre-COVID levels in the coming quarters. Other sectors we’ve liked include TMT, utilities and select HK issuers – targeting names with strong liquidity and/or low financial leverage.

What the tea leaves are saying for China and EM

Given China’s still sizeable fiscal buffers (U.S. $12.5 trillion in assets per IMF1) and socio-political considerations, a “hard landing” is still a very low probability in our view. The economy appears to be bottoming after continuous announcements of stimulus since early summer. However, we’re skeptical of a meaningful bounce without a significant structural rebalancing to reverse the declining potential growth. Geopolitically, while U.S./China relations have thawed in recent months, we still think the trajectory is negative, as tensions will rise again in 2024 due to Taiwanese and U.S. Presidential elections.

While China continues to have significant economic influence over EMD broadly, we believe that its impact is more balanced relative to the past decade given several factors:

(1) External imbalances are improving as policymakers have become more orthodox2.

(2) Commodity producers have turned more disciplined since the 2015 downturn while the oil-producing Gulf countries have rebuilt buffers to become net exporters of capital.

(3) EM sovereign and corporate issuers are much more diversified today, effectively reducing China’s overall beta to the asset class.

(4) The transition to renewables and increasing multipolarity arguably creates more opportunities for EM by creating new supply chains and allowing industries to develop in new countries and regions3.

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1 IMF: https://www.imf.org/en/Publications/WP/Issues/2023/08/02/Fiscal-Policy-and-the-Government-Balance-Sheet-in-China-536273

2 Emerging markets perspective: Shop local, Nuveen, August 2023: https://www.nuveen.com/global/investment-capabilities/fixed-income/emerging-debt-perspective

3 “Made in Mexico” gains further traction with nearshoring, Nuveen, September 2023 https://documents.nuveen.com/Documents/Nuveen/Default.aspx?uniqueId=06a5cf63-4437-47fb-9384-1f57a5d5fcb0

Endnotes

This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her financial professionals. The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forwardlooking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index.

A word on risk

Investing involves risk; loss of principal is possible. The value and income generated by bonds and other debt securities will fluctuate based on interest rates. If rates rise, the value of these investments generally drops. Fixed income securities are subject to credit risk, interest rate risk, foreign risk, and currency risk.

Nuveen provides investment advisory solutions through its investment specialists.

This information does not constitute investment research as defined under MiFID.

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