Geopolitical Tailwinds Propel Emerging Markets

You may not like geopolitics, but geopolitics likes emerging markets.

3 Reasons to Invest in EM

We've been making a case for emerging market bonds for a couple of decades now, and the basics are still there, low debt, independent central banks that pay you more, and exposure to commodities, upside exposure to commodities which is a tailwind for EM. But a headwind for a lot of the investments American investors have access to. But there's a new additional phenomenon that's accelerating the story for EM bonds, and that's geopolitics.

Eurasia: The land between Russia, China and Iran

How is geopolitics good for EM? Number one, the creation of Eurasia, a giant block of generally commodity exporters, represents supply risk that's generally very supportive of EM countries that are commodity exporters.

My favorite example is Kazakhstan. Kazakhstan provides 40% of the world's uranium. Uranium plants take about 12 to 18 months to refuel.

That alone is a good example of the types of supply risks that are the basic context of this new geopolitical reality.

Paying for oil with EM currencies creates demand from the central bank

Number two, paying for oil in EM currencies, paying for oil using EM currencies creates automatic demand from the central bank accepting that EM currency.

They have to buy the bonds of the EM country, if they're accepting that currency, and so that's a very positive technical.

The most famous arrangement is the petro dollar agreement with Saudi Arabia in which they will only accept dollars for oil. Now, what does that do to the Saudi Central Bank? It means that, if they're receiving dollars, they have to own treasuries. They have to own treasuries,

India agreed with UAE to pay Indian rupee for oil, and Saudi Arabia agreed with China to accept CNY for oil.

What does that mean? Well, that means that the Saudi Central Bank and the UAE central banks are going to be increasing their share of CNY bonds and INR bonds in their balance sheets by definition.

Now, we don't like those particular bonds, because we have an investment process, but there are many others in EM that are subject to the supply risk which I mentioned, but also to the increasing demand of central banks for EM currencies, because they can be used to purchase commodities.

It's a really key development, and it's a big game changer.

Geopolitical developments are accelerated by sanctions

All of these geopolitical developments are accelerated by sanctions. Sanctions on the Central Bank of Russia by the U.S. and Europe and Japan were sanctioning a creditor.

We're sanctioning countries that are lending to us. There are problems for the home country when you do that, when you cut off people from lending to you, but the most important thing is that other central banks saw this.

There's one big implication. The Brazilian Central Bank and the Chinese Central Bank and all the other central banks that have big piles of treasuries, U.S. treasuries as their asset, big loans to the U.S., they all woke up losing trust in them, maybe a tiny amount, maybe an insignificant amount, but not a zero amount.

EM bonds as possible replacement for Treasuries

It's all central banks looking to EM currencies, a broad range of EM currencies as assets, possibly in replacement for treasuries, which would be a huge development, but for sure, it's an ongoing phenomenon simply because the bonds are attractive in the first place.

I've been dealing with sanctions for decades starting with Iraq, North Korea, a lens most people don't have, because most people's attention started in Russia, but one lesson you can learn from following sanctions over a long period of time is that they never decline. They only go up. I think that's a scenario that needs to be contemplated.

The U.S. is hurting itself for reasons that are laid out, but the other side of it is that it's creating demand for EM currencies.

EM has plenty of opportunities in time of geopolitical stress

Overall, the fact that EM can do well and has plenty of opportunities in an environment of geopolitical stress is a great example of how, when you open your lens to include EM, you can find a lot of positive trends not just, for example, right now the inverted yield curve and the recession implied in the U.S.

These geopolitical developments may appear bad, and maybe they are in a lot of fronts, but there are a lot of winners, and most of them are in the emerging markets.