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CONTRIBUTORS

Nicholas Hardingham, CFA

Portfolio Manager, Franklin Templeton Fixed Income

Stephanie Ouwendijk, CFA

Portfolio Manager, Research Analyst, Franklin Templeton Fixed Income

Robert Nelson, CFA

Portfolio Manager, Research Analyst, Franklin Templeton Fixed Income

Joanna Woods, CFA

Portfolio Manager, Research Analyst, Franklin Templeton Fixed Income

Carlos Ortiz

Research Analyst, Franklin Templeton Fixed Income

Jamie Altmann

Research Analyst, Franklin Templeton Fixed Income

Preview

Over the past decade, sound policies, structural reform and strong growth have led to stark improvement among emerging markets (EM). When compared with the developed market (DM), it is evident that the gap in credit quality has narrowed. While DMs have seen a deterioration in their metrics since the COVID-19 pandemic, EMs have in most cases experienced superior growth rates, improving debt sustainability and strengthening fundamentals.

In this paper, we argue that the perceptions many investors have of EMs are typically neither accurate nor fair, especially for those investors less familiar with the asset class. In our analysis, EM fundamentals, in many cases, are superior to those of the DM world. Common preconceptions, which include riskiness, poor governance, high levels of corruption and unsustainable debt profiles, are inaccurate for most EMs.

Key considerations:

  • Fiscal: Is consolidation the path forward? The fiscal outlook for EMs appears more promising to us than that of DMs. This divergence is highlighted by key fiscal indicators such as interest payments relative to revenue, primary balances and debt to GDP, painting two deviating paths for these two asset classes.
  • Growth: The ever-important differential. A key strength of EMs has been the growth differential relative to DMs. Growth rates matter in the context of debt sustainability, as the higher the growth rate, the more expansionary fiscal policy can be without impacting debt levels. This means a country can run higher primary deficits without seeing debt-to-GDP grow. In other words, assuming zero primary deficits, a higher growth rate allows a country to outgrow its debt.

While investors are still justified in differentiating between DM and EM assets, EMs are improving to an extent that some now more closely resemble DM countries. The EM asset class is not a homogenous group, and any quantitative analysis should be combined with country-by-country fundamental analysis to fully understand the risks.

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal.

Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Investments in companies in a specific country or region may experience greater volatility than those that are more broadly diversified geographically.

The government’s participation in the economy is still high and, therefore, investments in China will be subject to larger regulatory risk levels compared to many other countries.

The allocation of assets among different strategies, asset classes and investments may not prove beneficial or produce the desired results.

Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a governmental entity may be unwilling or unable to pay interest and repay principal on its sovereign debt.

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