Where are the risks and opportunities in high yield and EMD?
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Where are the risks and opportunities in high yield and EMD?
With yields at higher levels in high yield and emerging market debt, Capital Group Investment Director, Peter Becker, discusses the key risks and opportunities in markets today.

What do you see as the key risks and opportunities in markets today?

Looking at on-the-ground activity, corporate profits have been strong, and most measures of economic activity have been relatively robust. However, the key risk is how the real economy responds to tighter financial conditions.

The US Federal Reserve (Fed), European Central Bank and other global central banks are tightening policy in response to higher inflation. These measures will inevitably cause a slowdown, but it remains unclear whether this pushes economies into recession, or we see a stabilisation at higher interest rates and lower growth.

The market is forward looking and has already significantly discounted these future risks. This is where opportunities may arise. Yields have re-set to higher levels. This means much of the aggressive central bank tightening and risks around economic activity have been priced into current valuations.

Across the emerging markets (EM) universe yields are between approximately 7% to 8%. For high yield (HY), the range is between 8% and 9%, depending on credit rating and sector. So, there is potentially a lot of yield cushion to compensate for the risk level. History indicates that yields at these levels could lead to very strong total returns over three-to-five years.

How would you frame the prospects of Capital Group Global High-Income Opportunities (LUX) in the current environment?

The yields I refer to above are some of the highest we have experienced in a long time in both high yield and emerging markets. At these yield levels, the forward-looking returns appear very attractive using the past 25 to 30 years as a guide.

While there is significant geopolitical and economic uncertainty globally, these concerns have been reflected in the negative total returns generated this year across all asset classes.

The advantage of a yield-oriented portfolio is that the income generated can help offset further volatility. The potential of a high level of income generation is a strong starting point to achieve solid returns over a multi-year timeframe. However, the longer-term time horizon is key; investors need to have patience to ride through the bumps.

The portfolio invests broadly across emerging markets and high yield. What is your current thinking regarding relative value between EM and HY?

We currently prefer emerging markets on valuation grounds. Our valuation models flag a significant divergence between HY and EM, with EM significantly cheaper on both a hard and local currency basis. Some of that valuation premium is justified because of more fragile economies and riskier credit profiles within the EM universe, and particularly for markets more directly impacted by the Russia-Ukraine conflict. However, the magnitude of the discount is approaching historical extremes.

Looking at broader macro issues, what are your thoughts on China’s growth trajectory?

I think the medium-term prospects for China are fairly challenging with growth facing both demographic and structural headwinds. While historically GDP has been buoyant at between 5%-7%, our analyst believes China’s economic growth could be almost half of that going forward.

However, in the near term the potential positives and negatives are more evenly balanced. The severe slowdown due to COVID restrictions and the energy shock could prompt the Chinese authorities to add more stimulus this year. A relaxation of COVID restrictions will likely lead to the economy picking up quickly, similar to the boost the US and Europe experienced after restrictions were lifted in 2021. This creates a positive near-term picture, but over the medium to longer term prospects appear more challenging.

Commodity prices have been remarkably strong, what’s your view on the sector?

I still have a constructive view on commodity prices because supply shortages haven't been alleviated. In many cases, supply issues have actually deteriorated yet global activity is still reasonable. So I think there's still a structural tailwind for commodity prices.

There is an interesting divergence in that the market has not rewarded the commodity producers for the strength in commodity prices. Perhaps there is a lag and will take more time, or perhaps the market isn't rewarding those currencies or those hard currency bonds the way it previously has for stronger commodity prices. Nevertheless, I still feel that on a fundamental basis commodity prices are in a fairly good place and the big question is whether valuations will move to reflect this.

Figures as of 30 June 2022. Source: Bloomberg High yield represented by the Bloomberg US High Yield Index 2% Issuer Cap. EM hard currency sovereign represented by JPMorgan EMBI Global. EM local currency sovereign represented by JPMorgan GBI-EM Global Diversified and EM corporates represented by JPMorgan CEMBI Broad Diversified.

Statements attributed to an individual represent the opinions of that individual as of the date published and may not necessarily reflect the view of Capital Group or its affiliates.

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.

• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.

• Past results are not a guide to future results.

• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.

• Depending on the strategy, risks may be associated with investing in fixed income, derivatives, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.

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