MFS® Emerging Markets Debt Strategy - Quarterly Portfolio Update

Hello, and thank you for taking a few minutes to hear about our outlook on Emerging Markets Debt. I am Katrina Uzun, an institutional portfolio manager responsible for overseeing Emerging Markets Debt strategies at MFS^®, and I am excited to share our insights on the global macro environment and our high-level portfolio positioning.

 Throughout the third quarter, US inflation data softened while the labor market showed signs of cooling, with job openings declining and unemployment rising. In response, the Federal Reserve shifted its focus from controlling stubborn inflation to supporting employment. In mid-September, the Fed surprised the market with a larger than expected 50 basis points rate cut, marking the start of a much-anticipated, non-recessionary easing cycle. Our current base case remains a soft landing for the economy. This macro backdrop is particularly favorable for emerging markets in the medium to long term, and I’d like to highlight three key reasons for this outlook.

 First, the Federal Reserve is easing and it is committed to staying ahead of the curve, driven by concerns about labor market deterioration. Second, China’s strong policy stimulus will bolster its economic growth, which in turn should support both emerging markets and global growth. Lastly, with the exception of China, balance sheets in emerging markets are generally in a very good shape. Let me expand on each one of these factors, starting with the Federal Reserve.

 The fastest tightening cycle in four decades is now behind us, and the easing phase has started. This is unambiguously positive for emerging markets. Continued US growth helps emerging market economies through trade channels, sustaining their growth and maintaining a healthy growth differential between emerging and developed markets, which in turn supports capital flows into the asset class.

 From the asset class return perspective, Fed easing is also a strong positive. Historical data from the first rate cuts in 2001, 2007 and 2019 shows that two-year forward returns for emerging markets following the initial Fed cut have been consistently strong, with returns in the high single digits. This highlights the positive impact of Fed easing on emerging market returns over the medium term.

 The second reason we view the macro backdrop as favorable for emerging markets is China’s stimulus. In recent weeks, China announced large, coordinated easing measures, with more expected. These measures are coming directly from the very top, including President Xi, marking a shift from the last few years when China's focus was on de-leveraging rather than stimulating growth. Today, the government understands the severity of the problem, which wasn’t the case even three months ago. The stabilization in China would provide strong support not only for emerging markets but also for risk assets more broadly.

 And the third factor supporting a positive macro backdrop for emerging markets is the strength of their balance sheets. Currently, basic balances in emerging markets, on aggregate, are in surplus, which is indicative of low to modest external financing needs for emerging market sovereigns. This is crucial because, if you recall, in 2013 when the Fed unexpectedly signaled its intent to begin tapering, emerging markets as a whole were running basic balance deficits. The “fragile five” countries — Indonesia, India, South Africa, Brazil, Turkey — had large deficits and faced considerable stress. Today, the situation is very different. External accounts and overall balance sheets in emerging markets are far healthier. This improved resilience helped them weather the recent Fed hiking cycle and will continue to provide support over the medium term.

 However, near-term tail risks remain, keeping us relatively cautiously positioned in portfolios. One key risk is the escalating tensions in the Middle East. There is huge uncertainty about when and how Israel will retaliate for Iran’s big missile attack on October 1, but there is virtually no doubt that it will indeed retaliate. This raises the risk of further escalation, more than a year after October 7, 2023, Hamas attacks on Israel.

Any further escalation could impact EM through higher oil prices. A sharp spike in oil prices would be negative for global growth and inflation, potentially causing a stagflationary shock to the global economy.

 While some emerging market oil exporters like Ecuador, Nigeria and Angola could benefit from rising oil prices, the immediate impact would likely be risk negative. It’s also important to remember that the Middle East represents almost a quarter of the Emerging Markets Debt benchmark. We have maintained a large underweight in the region for some time. Spreads in the Middle East are tight and do not reflect much geopolitical risk premium, and we believe higher premium is required given the current environment.

 The second near-term risk for us is the upcoming US election. A Trump presidency would likely put pressure on emerging markets due to his tariff-focused agenda, which could negatively impact trade and suppress growth in these markets. His policies would be particularly negative for countries like China, of course, but also Mexico, due to near shoring, or Central America and the Caribbean due to the immigration-related impacts.

 That said, during Trump’s first presidency, while there was negative momentum for risk assets for the first few months, emerging markets was able to bounce back and performed as well as, or better than, many other asset classes. For example, as shown by the red line on this chart, emerging markets sovereign debt delivered strong returns despite the “America first” policies.

 In contrast, a Harris victory would likely mean a continuation of the Biden administration policies. While fiscal deficits might widen, they would be partially funded by higher taxes on high-income individuals and corporations. This would help temper the rise in US treasury yields, allowing easing cycle and creating a more favorable environment for risk assets.

 Our approach has been to maintain the carry in the portfolio and focus on higher quality trades, adding stable, improving credits with strong balance sheets. We favor countries like the Dominican Republic, Paraguay, Costa Rica and Morocco — BB-rated economies with strong and improving balance sheets, sound policies and low macroeconomic imbalances. Additionally, we see opportunities in the single B space with countries like Angola, which has large fiscal and external surpluses, and Nigeria, an oil producer implementing important reforms, such as removing fuel subsidies, unifying the exchange rates and raising interest rates.

 Thank you for your time and for continuing to place your trust in us as we work to create value responsibly for you, our investors.

 

Fixed Income Investment Strategies Details

 

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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