MFS® Emerging Markets Debt Strategy - Quarterly Portfolio Update

MFS® Emerging Markets Debt Strategy — Quarterly Portfolio Update

Katrina Uzun, Institutional Portfolio Manager, shares the team's thoughts on emerging markets and provides a quarterly update on the Emerging Markets Debt Strategy.

Hello, and thank you for taking a few minutes to hear about the Emerging Markets Debt. I am Katrina Uzun, an institutional portfolio manager overseeing the Emerging Markets Debt strategies at MFS, and I wanted to take this time to share our perspectives on the global macro environment and high-level portfolio positioning.

We had a strong end to 2023. If you remember, the Fed ended its 500 basis points tightening cycle last July and then made an important pivot in November by signaling interest rate cuts in 2024. That propelled a risk rally in emerging markets debt in the fourth quarter of last year. That risk rally in the hard currency market continued into the first quarter of this year, as the market was pricing in the soft-landing sentiment, and the hard currency debt index returned positive 2% for the quarter. The overall global economic backdrop was favorable, driven by resilient global growth and higher commodity prices. But that strong US economic growth drove US dollar higher and weighed on emerging markets currency’s performance, so the local currency market finished the quarter with a negative total return of 2.1%.

We are relatively constructive on our outlook in emerging markets debt as the overall external backdrop appears more favorable. One of the biggest strengths of the asset class is that growth in emerging markets has been relatively resilient. You haven’t seen recessions anywhere, even though central banks across most of the emerging markets have been hiking rates. And a lot of people ask why is EM being so resilient with all of these rate hikes? And part of the reason why is because the external balances are in much better shape. External balances are an indication of how much external financing these sovereigns need. Those balances, on average, are in surplus today, which means these economies, on average, do not need to borrow. So that's a key strength because that really cushions these emerging markets from global slowdown. 

Also, something very unusual happened during this cycle: Many emerging market economies have raised rates ahead of the Fed this time. And now emerging markets are seeing broad disinflation. Real rates in emerging markets are very high, with plenty of room to cut back to their 10-year average, so that cushions them from dollar strength to some extent. 

There have been some improvements in the lower-rated segment of the market as well. There have been a number of countries in emerging market universe that went through a number of defaults and have now either completed or are in the process of completing their restructurings, helped by this positive global backdrop, which provides these lower quality countries — countries like Zambia or Sri Lanka — the room to make the adjustments they need to make. And then, we have positive stories like Argentina and Ecuador or Nigeria, where there's been political change, and the subsequent policy changes are bringing reforms both on the fiscal side and the monetary side. As a result, we see the emerging market investing environment is improving from where it was just two years ago.

Bottom line is that when you take the generally positive growth picture, good external balances, high real rates, the disinflation in emerging markets, the indication that the central banks will start to cut or have already started across many economies, the overall background for emerging markets is quite good. The challenge in emerging markets, as well as many other markets, both equity and fixed income, stems from tight valuations. Emerging markets debt spreads are at historically tight levels, if the most speculative countries (the CCC and below) are excluded from the benchmark.

The global backdrop is supportive for risk, but with tight valuations, finding attractive opportunities is difficult. We are being very selective in the risk opportunities we are adding to the portfolio, and we are maintaining our sell discipline of reducing exposure where risk-reward is no longer attractive. For example, we've added some of the high yielding countries with positive idiosyncratic stories and political and fundamental improvements. So these are countries like Egypt, Argentina, Ecuador, Nigeria and even Turkey. In the last six months, the fundamentals for these economies have moved into a positive direction and have created opportunities for us where all five of them, one year ago we were underweight, and today we are overweight all of them.   

At the same time, we added some select investment grade issuers that came to market during the first quarter — Hungary, Romania, Poland. So in the current environment, emerging market local debt has been selectively attractive, given the broad disinflation trend that we talked about, amongst all emerging market countries. But we have maintained local duration overweights in countries where policy rates are still above neutral and economic growth is below potential. We are underweight currency exposure, however, because we really need the fed to start cutting rates for the dollar cycle to turn. When the dollar weakens, emerging market currencies can rally providing a better entry point into the local currency market. 

With that, I'll say thank you again for your time and continued trust in us to create value for you, our investors, responsibly.

##PRODUCTS##

The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor. No forecasts can be guaranteed. Past performance is no guarantee of future results.

Important Risk Considerations:

The strategy may not achieve its objective and/or you could lose money on your investment.

Bond: Investments in debt instruments may decline in value as the result of, or perception of, declines in the credit quality of the issuer, borrower, counterparty, or other entity responsible for payment, underlying collateral, or changes in economic, political, issuer-specific, or other conditions. Certain types of debt instruments can be more sensitive to these factors and therefore more volatile. In addition, debt instruments entail interest rate risk (as interest rates rise, prices usually fall). Therefore, the portfolio's value may decline during rising rates. Portfolios that consist of debt instruments with longer durations are generally more sensitive to a rise in interest rates than those with shorter durations. At times, and particularly during periods of market turmoil, all or a large portion of segments of the market may not have an active trading market. As a result, it may be difficult to value these investments and it may not be possible to sell a particular investment or type of investment at any particular time or at an acceptable price. The price of an instrument trading at a negative interest rate responds to interest rate changes like other debt instruments; however, an instrument purchased at a negative interest rate is expected to produce a negative return if held to maturity.

Emerging Markets: Emerging markets can have less market structure, depth, and regulatory, custodial or operational oversight and greater political, social, geopolitical and economic instability than developed markets.

International: Investments in foreign markets can involve greater risk and volatility than U.S. investments because of adverse market, currency, economic, industry, political, regulatory, geopolitical, or other conditions.

Derivatives: Investments in derivatives can be used to take both long and short positions, be highly volatile, involve leverage (which can magnify losses), and involve risks in addition to the risks of the underlying indicator(s) on which the derivative is based, such as counterparty and liquidity risk.

High Yield: Investments in below investment grade quality debt instruments can be more volatile and have greater risk of default, or already be in default, than higher-quality debt instruments.

Please see the applicable prospectus for further information on these and other risk considerations.

The portfolio is actively managed, and current holdings may be different.

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