Investing in Emerging Europe & Beyond

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Voice-over: Welcome to Fixing Your Interest. In this episode, we’re joined by Yacov Arnopolin, Portfolio Manager and co-chair of PIMCO’s emerging markets portfolio committee, and Michael Davidson, Portfolio Manager in PIMCO’s emerging markets group. They discuss the rebound in emerging markets, the rise of local currency strategies, and the evolving role of frontier economies. With insights on credit quality, currency dynamics, and political risk, Yacov and Michael highlight how improved policy frameworks and diversified benchmarks are shaping opportunities. Their practical perspectives on macro tailwinds and active management guide investors through today’s EM landscape.

MIKE DAVIDSON: I'm Mike Davidson, an emerging markets portfolio manager here at PIMCO, and I'm here with Yacov Arnopolin, another emerging markets portfolio manager. Yacov, it's great to see you here in our London office. I know you've been very busy on the road recently travelling meeting our clients in Europe and beyond. What's the mood like?

YACOV ARNOPOLIN: Well, thanks Mike, and good to see you and good to be in London. I would say it's quite nice to see, feel this comeback of emerging markets after, you know, many years of concern of outflows. You know, I always say we had this a hundred-year storm in EM around 2021 and 2022 because of Fed hikes, ECB hikes, you know, geopolitical events, outflows that naturally led to defaults.

And, you know, after 157 billion of outflows, you know, really huge figure, 157 billion over the past, you know two, three years. So again, that 2021 - 2024 period we're starting to see green shoots, but it's really still really it, I would say it's just a kind of sliver of what has exited that's coming back. So it feels like certainly there's room for more and clients are very excited and, you know, a lot of questions both about credit hard currency, emerging markets, about local currency emerging markets, about currencies in particular.

I think some of that is on the back of the fact that increasingly the volatility that people witness in developed market fixed income in developed markets in Europe and the US, you know, is prompting them to ask where can we potentially diversify into, you know, so we really think the incremental euro or dollar of investments within fixed income is quite likely to be captured by emerging markets. And I think really the debate then becomes, is it going to be hard currency or local currency?

And whereas in the past 1, 2, 3 years, all money coming in, whatever money was coming in, and it was mostly our investors kind of changing their managers rather than new funds as I mentioned. This year, in fact probably since liberation day it really has become 50-50 with local currency gaining ground and people really thinking about what are the prospects for EM currencies to continue to perform.

So it's very much this push and pull, you know, a little bit of diversification out of the US dollar and also, naturally people thinking about the potential of EM FX of EM currency. So, maybe I can turn to you as our local markets expert and when you think about macro in EM and when you think about inflation and growth prospects, you know, do you think that pivot to local currencies is justified.

MIKE DAVIDSON: Yeah, it's funny you talk about the tricky period between 2021 and 2024 because as you well know, for local currency investments, it really has been sort of somewhat of a lost decade. You've seen assets under management tracking the local indices, basically stagnant since maybe 2013 or 2014. And really it's only this year that we're starting to see more interest coming back. And I do think it's the diversification angle that you mentioned.

And I think there's been a bit of a change in perception in terms of EM local currency investments. For a long time they've been viewed as a high risk part of the spectrum and the volatility has been much, much higher than other fixed income indices. But what you've seen over the last maybe two or three years is that volatility has come down at the same time as you've seen volatility in other fixed income indices rise.

And so now you're looking much more in line with the pack at the same time, you're still getting very attractive yields on a lot of your local currency investments. I think this is testament to the good job that a lot of EM policy makers have done over the past, five or 10 years diversifying their sources of funding towards their local currency markets, acting proactively during periods of stress to offer high yields to investors and being a bit more prudent on the fiscal side as well.

There's a lot of concern globally about fiscal policy and governments spending too much money, that feels like a cycle that we've been through in the past in emerging markets, and really policy makers have been taking that very seriously. So you are ending up with deficits and debt levels that compare pretty favorably to developed markets.

YACOV ARNOPOLIN: Yeah. And just if we get a little more granular on local currency angle, you know, when we look back, you mentioned, the past performance, or at least there have been years where it's been a very volatile beta, the benchmark has been very volatile, but the benchmark has also evolved. And I think people don't appreciate the fact that now with the inclusion of China, India, now potentially, you know, Saudi Arabia, this is a much less volatile benchmark, you know, potentially with just, you know, with a more favorable outlook versus developed market rates. Is that fair?

MIKE DAVIDSON: I think that's absolutely fair. The overall returns of the benchmark are no longer dependent on one or two key and very volatile countries it’s a much better diversified index now, I think. And the return streams are a lot more stable, and you've seen that in the falling volatility of the beta. So I think that's something that has attracted people to start reconsidering local markets investments.

And there's a lot of countries now that are becoming investible. You have talk about frontier economies, for example, that we as active managers have been looking at investing in. So that replaces some of the yield that you might be giving up with some of these more stable markets.

YACOV ARNOPOLIN: So, can we talk more about frontier? Because when I, on the hard currency side, for us, frontier certainly has been a fantastic driver of returns both underweights and the overweights, you know, naturally a lot of volatility, but generally, we certainly have seen a healing cycle over the past several years. A few countries that defaulted have restructured, they have new bonds, they're not paying much in terms of coupon, but that's fine.

It also means there's very little probability of a kind of redefaulting anytime soon. So, you know, we're looking at literally all the scope of countries we invest in. There's 70 plus in the hard currency benchmark. There's probably another 10, 15 we invest in off benchmark that may eventually enter the EMBI benchmark. And when I look across the board, I really cannot think of a single country at risk of default on a 12-month horizon, even 24-month horizon.

And there was an industry report recently that took it further and said, really no defaults, you know, before 2030. And, that's mostly because that's how far this report was, that it was forward looking on five-year kind of horizon. So, there is a lot going on in frontier markets. I mentioned a lot of healing, still very elevated yields when we compare emerging market sovereigns to developed market sovereigns.

When we compare emerging market sovereigns to corporates in Europe, in the US, they really stand out to me still, especially some of the double B, the single B cohort as offering a lot of risk premium even after the rally. And as much as, you know, we are bond managers, we're always worried about the next crisis, the next recession. Even then, even if we witnessed a recession in Europe and the US, it's still difficult to conceptualize other than the natural beta, you know what credit, to the extent credit widens, everything will widen.

But you know, EM wouldn't be the epicenter of that, EM wouldn't be the source of that crisis of that recession. So will EM get touched? Yes, but to me it's, again, there'll be some correlation, but I really don't see that as anything that will be systemic for emerging markets now because how clean the balance sheets have become because of the IMF support, because of the World Bank support, because they've weathered these crises.

But then, you know, I always think in our portfolios about the tradeoff between the exposure to frontier via hard currency bonds and frontier currencies. And frontier currencies, it feels like it's a nice way to add a little bit of some spiciness to the portfolios. But, you know, those have been great drivers of return, so how do you think about the opportunity set there and what are you seeing in terms of on the local side, currencies, rates?

MIKE DAVIDSON: I think it's, everything has to be taken on a country by country basis, but what you have seen is a number of countries learn from the mistakes of the past in terms of allowing their currencies to become very overvalued maintaining fixed exchange rates. And actually they've fixed a lot of those problems now and they are offering extremely appealing yields at a low volatility. So I think there's a number of…

YACOV ARNOPOLIN: They fixed the problems, they devalued, right?

MIKE DAVIDSON: Not just devalue, I mean, devaluing was a part of fixing these problems, but hiking interest rates, sorting out their fiscal deficits, making sure they're securing financing at concessional levels from, as you mentioned, the IMF, but also regional partners as well. So a lot of the problems that you had in the past have been, have been addressed in a way that leave these stories attractive to investors.

At the same time, it feels like they're a little bit further from the beaten track. Maybe other managers don't have the size and scale that we do to unearth the opportunities and therefore take advantage of some of these yields that are on offer.

YACOV ARNOPOLIN: You know, it's when we talk about the presence of additional support and whether we talk about IMF or World Bank or you talked about regional partners, and I think that's what the market and some folks underappreciate is how much things have evolved both the technical as well, also the geopolitics. You know, we witnessed a couple years ago, Abu Dhabi throw a lifeline to Egypt, right?

So, you know, we're seeing increasingly it's not just the usual suspects, you know, the IMFs and the world banks that are able to offer support. There are many more multilateral institutions, the African Development Bank and so on and so forth, that certainly have the muscle and the balance sheet to potentially support countries in the region.

And well, we shouldn't forget now, the US has been obviously quite, quite active in Latin America more than anything, but also beyond we naturally saw this the bailout if you want, or the currency swap the support offered to Argentina, you know, relations are very strong between the US and Nayib Bukele in El Salvador.

So, you know, we shouldn't discard that as an additional source of potential support. So we look across the globe at who are the allies and could the allies be rewarded, you know, via, you know, this additional support, these additional swap lines or, you know, something along those lines.

So again, there are, it's a complex picture and I feel like as an emerging markets portfolio manager, you become a little bit of a geopolitical expert because it's not just figuring out the next crisis, but also, you know, what other players can be there as a lender of last resort to basically kind of lend a hand if needs be. Again, I think that has been potent.

This other topic that you mentioned in terms of the growing sophistication of local markets. Now, what are you seeing, let's say 10 years ago versus now in terms of, in the local market space, how much of that is foreigners versus locals, and how much, how has that evolved?

MIKE DAVIDSON: Yeah. Because of this lost decade in terms of offshore investment in local markets in particular, you have seen a lot of emerging market countries develop their own financial architecture to be able to finance themselves. And what many people don't realize is these pools of capital have become extremely large. I mean, I remember you telling me about your trip to Chile recently and really appreciating the scale of the local pension systems, the AFPs there, but it's the same in Columbia…

YACOV ARNOPOLIN: Mexico…

MIKE DAVIDSON: Same in Mexico. It's the same in South Africa. And that's become a really important sort of source of stability for a lot of these markets because when you have maybe more pro-cyclical investors trading around the markets, you have these deeper pools of local capital that are able to provide bonds at maybe stretch levels, but also more importantly, perhaps absorb bonds in times…

YACOV ARNOPOLIN: It is evolved suppression, basically.

MIKE DAVIDSON: Yeah, absolutely. And we talked a little bit about volatility already and how emerging market volatility has fallen. This has been an important driver, both the growth of these domestic pools of capital and also then the skew towards issuing in local markets, which has reduced dependency on foreign exchange as a shock absorber.

YACOV ARNOPOLIN: And, maybe a slight pivot to, you know, ESG, because, you know, this is top of mind for many investors in Europe, you know, as this recent trip in to the continent, once again, ESG is front and center. We do a lot on the hard currency side. We're very blessed that PIMCO do have a large franchise and large emerging ESG team that we work with. For you on the local side, is that also an evolution? Is that coming to the fore?

MIKE DAVIDSON: Yeah, it's been an area of real focus and growth for us. You've started to see countries issue more green bonds and label bonds in their own currencies. And at PIMCO we have sort of best practices that we're able to share with these sovereigns when they're looking to develop their green programs. So I think it's a trend that's going to continue. We're still seeing a lot of interest from it from a diverse client base. So I think that it'll be increasingly important as sovereigns look to diversify their financing, that they're able to tap into these pockets of capital, which are more ESG focused.

YACOV ARNOPOLIN: But that brings me to the topic of corporates versus sovereigns. And, as much as we see a lot of ESG issuance on the corporate side, we've been fairly careful in terms of how much exposure we want to have in to corporates.

Some, they're a great diversifier in many cases. You know, we have far better balance sheets than developed markets. You know, many of them actually have businesses in developed markets, but they have headquarters in emerging markets and they get penalized. So there's really, I think, I feel we're blessed as EM portfolio managers as Emerging Markets portfolio managers.

Because the universe is so wide and there's so much for us to pick from literally going from frontier currencies to local rates FX, you know, hard currency sovereign bonds, hard currency corporate bonds, ESG issuance.

MIKE DAVIDSON: I mean, ultimately it comes down to liquidity I think. We always had to be conscious as investors in Emerging Markets of the liquidity profile of the investments. And I know you and I both spend a lot of time when we look at our portfolio to understand our ability to move the underlying assets around particularly as the funds grow larger.

So, I think that's one of the things that to the extent that the corporate market develops better liquidity in some of these higher rated names, the quasi sovereign names have comparable liquidity to their underlying sovereigns. But again, as you get lower down the quality spectrum, you're really not just taking beyond the fundamentals of the company, but also in terms of the liquidity of the market.

YACOV ARNOPOLIN: Yeah, it's curious. I've been speaking a lot with our corporate credit analysts, and anytime I spend time with them, which is a lot, I always learn something. But also just like the focusing on the details matters and focusing in different countries have different bankruptcy codes, and as much as we talked about Brazil, I think most of us expect that creditors will have preferred, you know, status, so to speak, but in their countries with a kind of Napoleonic code, in many cases, that's not assured.

And, sometimes critique may have high recovery. So again, really have to be nuanced and have to be look at every single opportunity and look at every single country. Again, I think that's where having a large bench of corporate analysts, economists, PMs has helped a lot in terms of being able to do the work and dig deeper and understand what the real risks are. And again, back to my point as a fixed income portfolio manager, you know, we're paid to worry and that's what we do.

MIKE DAVIDSON: Yeah, absolutely. But as much as we talk about worrying, actually the macro outlook for Emerging Markets is pretty good at the moment. You have a Fed that's been cutting interest rates, you have a dollar that's been weakening, but

YACOV ARNOPOLIN: Which is actually, it feeds back into corporate credit. Well, Emerging Market credit spreads, because all of that is quite supportive, stronger FX good for credit as well. So people forget that they're both…

MIKE DAVIDSON: The thing about emerging markets is to many extents, it's a virtuous cycle in all of these assets. They become self-reinforcing and, kind of paradoxically, even though the valuations may look more expensive, that has actually reinforced the underlying macro as well. So it gives the performance of assets a little bit more durability, a little bit more runway into the future.

You think about stronger FX leads to lower inflation allows central banks to cut interest rates, which means that government financing costs are lower, which means that the corporate sector is not getting crowded out by government issuance. So all of these things kind of feed on each other and allow more runway. I mean, it was the same dynamic in reverse in the challenging period that we saw. And the fact that emerging markets sovereigns managed to weather that period of extremely tight financial conditions, strong dollar, default cycle.

They've come through the other side now and many, many of these countries are well placed to reap the rewards of the virtuous cycle that I think we're seeing and the diversification of global investors who own a lot of US assets, and it's been a great trade for many years, but as they're looking to rebalance their portfolios, maybe pivot a portion of that away emerging markets, again, are poised to benefit from those flows as well.

YACOV ARNOPOLIN: Alright, so I'm going off script here. Unsolicited questions. Speaking of the dollar I think something that comes up quite frequently is, can EM currencies do well if the dollar sort of grinds weaker, it just kind of stabilizes at current levels, you know, what's the argument then for EM FX?

MIKE DAVIDSON: Absolutely. I think that's a great environment for EM currencies, ultimately EM currencies, one of the reasons that people invest in them is because of the carry. And the best environment for a carry trade is a low volatility environment. So to the extent that the dollar stays where it is, grinds weaker, but in a stable fashion that's a very benign environment for emerging markets. And you're likely to see the highest yielding parts of the emerging markets universe do particularly well.

But that rising tide should lift all boats. I mean, in many ways that's a better environment than when one where you're seeing sharp dollar weakness, which could be linked to maybe US economic weakness. And growth shocks can typically be negative for riskier assets. And emerging markets, we discussed before, maybe unfairly, but they're very often bucketed in that part of the universe.

YACOV ARNOPOLIN: Yeah, it's something that I always try to differentiate as well. Those of us focusing on credit or just hard currency bonds and there is a little bit of a I guess there's a sense of mean reversion or that, you know, maybe things ultimately repay at par, maybe they go above par if yields really rally, but there is this notion that things will mean revert and ultimately there's that sort of gravity. And it's quite distinct with currencies, right?

Currencies are not necessarily mean reverting, currencies can run much further, assuming the fundamentals are justified and in the meantime can also offer a lot of carry.

MIKE DAVIDSON: Yeah, absolutely. And I think one of our jobs as portfolio managers is putting the pieces of the puzzle together. So looking at the valuation of the currencies on various metrics, looking at how the performance of the currency is interacting with the balance of payments. So an overvalued currency might mean that your imports start growing very fast because it's cheaper to import goods rather than to produce them domestically.

And it's our job to look for when these imbalances are starting to grow and then maybe question sustainability of the currency performance. But really what we're seeing at the moment across emerging markets is the external balance sheet is mostly in good shape. There's a few noticeable examples where there's not necessarily the case.

But on the whole balance of payments, I think looks, looks really good. And that again gives me confidence that emerging assets can continue to perform on both the local currency side. But then as we've discussed, local currency assets doing well is really supportive for credit as well.

YACOV ARNOPOLIN: So, maybe that's a good, you know, pivot in terms of just talking about next 3, 6, 12 months, you know, favorite places to you know, where do you have a favorable view, which countries, which currencies, which bonds?

MIKE DAVIDSON: Look I think our playbook this year has really been look for two different types of trades. The first is these places where there's been a big shift in policy towards cheaper currencies, high yields and then stable FX afterwards. And that's mostly played out in the frontier space, so Egypt and Nigeria. But another place that that's really played out has been Turkey.

There's been a very concerted effort to get inflation down, offer high yields to generate FX stability, both for offshore investors, but also importantly, domestic investors need to be given confidence to reinvest in the Turkish lira, and their own currency. So that's been a very interesting space. The other sort of big theme in terms of trades that we've liked has been places where there's been a benign inflation trajectory, low inflation, but also steep curves.

So that's been one place where we've sort of looked at Peru, for example, and South Africa, both places where inflation has fallen dramatically. South Africa actually lowered their inflation target, or they prefer to call it a preference to see inflation settle at the bottom of their inflation targeting band. So they've moved that from 4.5 to 3%.

And that obviously has had very positive implications for how investors think about medium term bonds in South Africa because you're now expecting inflation over the medium term to be 3% rather than 4.5%. But maybe I'll throw that question back to you. What are the sort of top of mind trades for you, but also how are you thinking about political risks as you shape your portfolio?

YACOV ARNOPOLIN: Yeah, of course. Well also a lot to do on the hard currency side. It's been an exciting few months and remains quite interesting to observe. Also, curiously, as countries that have been locked out of capital markets are able to reenter capital markets because, you know, the yields are lower, it really becomes a virtuous cycle. So, it's a little counter intuitive.

People normally would say, well, there's going to be an extra 2, 3, 4, 5 billion issued in the market that should put pressure on existing bonds. In reality, for some of the high yielders, it actually prompts a rally in their existing paper because all of a sudden after 2, 3, 4, 5 years of being locked out of capital markets. That's yet another source of financing that has just reopened. And we witnessed that in Egypt, in Angola, you know, in Nigeria some time ago.

So again, it's actually fairly positive. So you, for us, what has worked very well, we have been quite positive on Angola. That has been a very nice trade. I think they continue to do well, you know, there is more sensitivity to oil prices there. Yeah, really to me, having this active management approach and having a large team has really helped us as well.

And then your question about political risk, well, you know, this is, again, this is where we're always worried and we try not to take a view on politics because these days polling is, and ultimately results can really diverge and all these elections can be quite unpredictable anywhere in the world, you know, but generally speaking, we may see a net favorable transition next year.

We're going to have elections in Chile, we're going to have elections in Brazil. So, you know, it's still a very busy calendar. Now, I think it's going to create opportunities, so it's kind of always exciting times in emerging markets. Lots to do.

MIKE DAVIDSON: Yeah. That's for sure. There's always something to look at. There's always something happening. But it's great to be feeling like we're in a spot where things are going well and there's good runway for assets to continue to perform.

Thank you very much for listening and we hope you found it interesting.

Voice-over: Thanks for listening to Fixing Your Interest. Today’s episode explored the momentum in emerging markets—from FX stability and frontier recoveries to macro tailwinds and political transitions. We examined how evolving benchmarks, local capital pools, and active strategies are reshaping the landscape. For more perspectives on global fixed income, subscribe to Fixing Your Interest, share this episode, and visit PIMCO.com for expert analysis and resources to help you stay informed in a fast-moving world.