EM_Q4 2025 update
Welcome to the Q4 2024 update for the Vanguard emerging market bond fund. This number one performing fund continues to deliver consistent alpha of 4.3% a year on average since inception, and it has outperformed the benchmark and the peer group in every calendar year since inception. And it's been doing this without relying on big macro calls, large beta, or duration positioning to generate outperformance. The fund had its fifth anniversary last month back in December and is generating lots of interest. Joining me, as usual, is Nick Eisinger, co-head of our EM active team.
So, Nick, headline news in Q4 was dominated by the US presidential election. But behind the scenes, the Fed, whilst cutting in December, were overall less dovish and that strengthened the dollar. It rose US yields, obviously impacted your asset class. At an index level, hard currency spreads seem to tighten a little bit. But perhaps you could walk us through your viewpoint?
Of course. Absolutely. Always good to be here. So Q4 was tougher than previous quarters. A lot of that was around the tone set by the Republican victory and concern over some of the policies that are going to be delivered by the new administration. And obviously, we're seeing some of that in real time right now.
EM, overall, certainly, EM credit, actually took that quite well into its stride. So, as you say, we saw at an index level things tightened a little bit. And what's particularly distinctive is that some of the high-yield names continue to rally pretty significantly right through to the end of the year. And actually, we've continued to see some of that rally in the early stages of Q1 as well.
And so yeah, there's definitely this bifurcation between high and low quality. Your fund outperformed again-- 34 basis points in a quarter. That added up to 110 basis points over the whole of 2024. What were the drivers of that outperformance?
So yes. Last year was another year where we were able to not only beat our alpha targets, beat the benchmark. I would say, looking back, we mistimed a few things. We probably exited some of the high- yield positions a little bit too early.
But notwithstanding that, I think it's testament to our process-- particularly around selection, as opposed to big macro bets, as you articulated-- I think it's testament to that we continue to be able to meet our targets and beat the benchmark despite making, what you might want to say, a few mistakes.
So high yield for much of the year, particularly in some of the countries that came out of restructuring, that was a pretty good bet for us. So we've made money, and we continue to make money as I speak in positions-- long positions in countries like Ghana and Zambia. And we've actually been building those positions through time. Those are positions that take time to build up because those bonds sometimes are hard to source. We think those are positions that should pay off well in 2025 as well.
We continue to hold a decent portion of certain bonds issued by Ukraine post the debt restructuring, and those have continued to rally. There's obviously a Trump "end the war" narrative there that is still alive and well. So that is an interesting theme for us to continue to trade.
And then at a broader macro level, given the uncertainties around what the US administration is going to do, as well as what you've already said around the Fed not changing path so much, but the Fed dialing back a little bit with some of the rate cuts that were priced in for 2025, that effectively meant a strong dollar. So we actually made some money in FX by effectively being long dollar versus a few EM currencies, as well as some more G7 currencies, such as the euro. So dollar to euro was quite a successful strategy for the fund in Q4.
And looking at fundamentals of countries, we saw-- it was good to see more upgrades than downgrades quite significantly. So does that mean it was a stock-picking environment for you? And do you see that environment continuing of more upgrades than downgrades?
I mean, I think the overall direction of fundamentals, if you like, is stable to slightly improving for the index as a whole. So obviously, last year we saw a range of countries come out of either SD, selective default, or somewhere in the deep single Cs, into triple Cs or B-minus. That's obviously at the lower end of the spectrum. And that really is just a reflection of the fact that these countries are now current with the new bonds that they've issued post-restructuring.
We've seen some upgrades and improvements in places like Turkey, which continues to be one of our favorite picks for this year-- across asset classes in Turkey, that would be. So that's credit at the sovereign level. That's FX, which continues to be, I think, a pretty good carry trade. And we're getting more and more into some of the local duration as policies have shifted. So Turkey got the upgrade.
Then we saw some more questionable fundamental stories, particularly around two countries, both of which are pretty prominent in the news right now. One is Romania, closer to home, which perhaps we could talk about. And the other one is Panama, slightly further away from London.
But obviously, Panama not only faces some of these uncertainties about Donald Trump's aspirations to change the ownership of the canal, but it also faces a deterioration of its own fundamentals. And when you have these two things in combination, usually it makes a volatile and downward markets.
Yeah. So let's start with Romania then. It's an interesting case study, isn't it, of index with the USD and then the euro. Perhaps you could walk us through that. And then also, the fundamental case of Romania.
Of course. Great question. So Romania remains an investment grade country. EM dedicated investors are, to be honest, quite indifferent as to whether a country is IG or non IG. We focus on that because it can change the technicals of the market.
But Romania is a country that's seen a lot of what we call crossover investors, who tend to value the investment grade rating quite a lot. And over the past year or two, Romania has seen a very meaningful deterioration in its budget deficit.
So it probably ran a deficit close to 9% of GDP in 2024, from somewhere closer to 6 and 1/2 to 7-- that was the initial target. And it runs a very large external deficit as well. So not only are the numbers gradually deteriorating, this means that it has a very large funding need.
So the Romanian authorities had to visit the Eurobond markets across dollars and across euros last year to the tune of about 15 or 16 billion euros, which is a big number. It looks like that's a similar sort of number for this year, maybe a little bit less.
They have just recently received some negative outlooks from two of the rating agencies. It's likely they'll receive a third. So now the market, which has sold off a lot, and we've been fortunate in having a very underweight position there, is debating whether that investment grade rating is going to last.
And Panama, you've talked through the challenges it's facing. How do you play a name like that and the name in the fund. Is that just something you step away from? And perhaps then we can move on to Ecuador, sort of similar sort of question.
Sure. Well, I mean, it's all about the price. It's all about levels, really. So Panama-- as our research team started to deduce that the fundamentals were on a worsening path, valuations were still very tight. So it was a relatively easy decision for us on a fundamental adjusted basis to take an underweight position there.
That's something that paid off quite well. Pricing is obviously a bit more attractive now. But there's still a lot of uncertainties. Will the administration in Panama undertake meaningful reform to set things back on an even keel? We question that at the moment.
And then there's what probably will end up being noise around what the White House has said with regard to Panama. But that's very unhelpful noise in a market where there's already uncertainty around the broader US policies. We've seen something recently vis-a-vis the Colombians, obviously.
And so if you're a country where the fundamentals are already impaired, and the market is focusing on you and you get this noise, as I said, it's usually a volatile combination. So you need to be a bit careful.
Yep. And with something like Turkey, you've got so many different ways to play a name like that. Same with something like South Africa. Is Panama-- do you have those options?
Not really. No. So Panama is a dollarized economy. So really, the only way that you can play Panama is via the credit, effectively.
And moving on to a good news story from a spreads point of a Ukraine-- that was one of the key stories in Q4 and the second best contributor to the fund. How did you see that play out, and what's your outlook for their debt?
So I think Ukraine's useful to think in terms of reality and themes. So the reality is no one really knows what's going to happen. It's very hard to have any meaningful insight into how the war plays out, whether the war ends.
But it clearly got a big respite when at the back end of the summer, it came out of the restructuring, and it issued a series of new bonds. And at least two of those bonds have some very interesting features attached to them. And to cut a long story short, those features effectively mean under certain conditions. And those conditions are greatly enhanced in a scenario of the war ending.
So under those conditions, the value of those bonds potentially doubles. So the market has obviously latched on to this. And I think it's taken a view there's uncertainty. But Ukraine is still yielding a very high overall yield or a good spread. We don't want to be at zero on Ukraine. So these are probably the bonds that we should own.
And so what we've seen is there's some very interesting opportunity for security selection. And we tend to hold the bonds that have rallied the most. We still think there's more to come. And you can be a bit more indifferent to some of the other instruments within the Ukrainian complex.
So we'll see how this all plays out. Obviously, the White House has moved from a proposal of the war ending at day one to perhaps a longer six-month period. And I think we're going to get a lot of back and forth. But the market is still quite confident of that theme.
And again, it's a theme. It may not happen. And what it means is with most themes in financial markets is we would not hold these bonds until that top level price is achieved. So you can run a model, and it will give you a price. You most likely want to be exiting these positions well before that top price is reached and when that theme has really run its course, if you like. So we spend a lot of our time establishing in our minds, when and where that will happen.
And last country-specific question. Colombia, which was one of our top-performing names. I remember talking about you about a year ago, and you were actually quite negative on Colombia. So has anything changed, and how did you make money out of that?
The main thing that changed was the price. So at the margin, there's been a little bit more reform to sort out some of the public finance challenges that the Colombians have. But really, the price changed.
So a lot of the negative fundamental view that we had, which had prompted us to have an underweight position earlier, started to be reflected in prices. And so we felt that some of that bad news was already in the price at that stage. And so we were able to buy at much more attractive levels. So it's a trade that we sort of-- I wouldn't say we have a structural long on it. It's something that we trade around quite tactically.
We've also made some nice P&L or alpha for the fund by trading some of the local bonds in Colombia. So that's another area where you can do some relative value between credit and between rates, and indeed, between FX.
And with the Fed being less dovish and inflation seeming stickier in developed markets, and in EM, arguably, what's your outlook for the asset class? We'll hopefully expect more alpha from you next year again, but at an asset class level. And with that in mind, what role could your fund play in the portfolio?
Sure. I mean the outlook is a bit more clouded for the asset class. But as market participants have seen in the past few weeks, the Treasury market continues to move up and down for all sorts of reasons. Is Trump going to be aggressive on tariffs? Is he not? And the market literally moves a lot within one or two days over that.
At the moment, there's a little bit of euphoria because the White House has not yet-- and "yet" is the operative word here-- it has not yet come out with a very aggressive structural agenda around tariffs, and so the market's taken some respite from that. We think that could change.
We're less clear in our minds exactly how inflationary tariffs would be, however. So we now think about G10 or US duration. And as a factor in our fund, we quite like it. Because last time we were talking, there was probably three or four rate cuts priced in for 2025 from the Fed. As we speak today, there's barely one. There's obviously going to be a lot of soul-searching, mind-searching as to where that goes.
We do detect some signs of things slowing down a little bit at the margin in the US economy. And, again, at some of the levels we've seen in the past week or so, we think adding some duration is a relatively decent bet. So if we're right on that, then EM is likely to have a reasonably good year.
We have to be right on both parts of that. We have to be right on the fact that the Fed might get a little bit easier than the more hawkish pricing that we've seen the market adopt. But we also have to be right on the reason for it doing that. So the reason would be perhaps there's less stimulus coming out of the White House than had been anticipated.
Because if the reason is that the US economy is actually going to go into a negative tailspin, that is not good for emerging markets either. So you need to navigate this middle ground. And for us, that's a pretty reasonable base case that you will navigate the middle ground.
At a base level or a index level, are you going to generate super exciting returns in EM credits? No, but they'll be adequate. And I think they'll more than hold their own against some of the other major fixed-income asset classes.
But, as you know, and our clients know, while we look at beta, it doesn't matter to us too much. So we will be pretty confident in more volatile markets that we can add decent amount of alpha from our selective approach on top of what you're going to be making at the index level.
And you've got the-- for when you're not quite right, you've got the carry there with the very attractive yield--
Yes, exactly.
--to make up for those.
Yeah.
Yeah.
Nick, as always, thank you very much for your time.
Thank you.
