New walls and broken bridges
Russia’s invasion of Ukraine and China’s growing assertiveness have important consequences for global markets. These consequences may not be as predictable as some would imagine.
23 Nov 2022
Hear Peter and Werner discuss the outlook for EM sovereign debt.
Emerging market (EM) debt has been caught up in the general fixed income bear market – driven by rising inflation, monetary policy tightening, and risk aversion associated with the volatility of inflation and rates. What’s different from other bear markets is that rather than underperforming significantly, EM debt market returns have been broadly in-line with global bond markets, especially if you exclude Russia, which was marked down to zero. We think this speaks to the fundamental strength of EM economies today.
In 2013, a lot of investors had flooded into EM assets in search of yield, leaving valuations stretched. In addition, with hefty current account deficits some key EM economies were net borrowers of US dollars and vulnerable to the US rate-hiking cycle. The picture in 2022 is markedly different, not least in terms of fundamentals: EM balance sheets have improved a lot, with current accounts flat or in surplus. This helped EM economies to weather the storm much better in 2022 and supports the view that what we’ve seen in bond markets is a global phenomenon, not an EM crisis.
The steps taken by policymakers in EM – who have learned painful lessons from the past – have helped put many economies on a strong footing. When inflation began to rise, EM central banks acted quickly to prevent it spiralling out of control. At the time of writing, 11 of the 18 largest EM local bond markets had seen rates rise by more than the hikes meted out by the US Federal Reserve. Four had even paused hiking, having successfully reined in inflation. With EM inflation subsiding and much of the painful rate hiking done, nominal GDP is now rising and debt-to-GDP ratios falling. Coupled with strong fiscal positions, the overall picture for EM is robust. Reflecting this, at the IMF/World Bank annual meetings in October, most discussions around financial stability concerns centred on developed markets rather than EM. That said, the EM debt universe is diverse and there will be pockets of vulnerability given the challenging outlook, necessitating a selective approach to investing.
While funding challenges are not an issue for the core EM economies, some frontier markets are vulnerable, with Africa a key region caught up in the ‘sudden stop’ in foreign investor flows seen in 2022. However, the IMF appears intent on ensuring that liquidity risks do not spiral into solvency risks for countries that are engaged in the right reforms. Furthermore, we believe market pricing has already reflected these risks to a great degree.
To understand which countries are most vulnerable to tighter global liquidity conditions we use a proprietary credit vulnerability model. This looks at current economic, fiscal, external and institutional factors of each country relative to peers and history and then combines this with a consideration of external liquidity vulnerability (reserves and gross external financing needs). We find a ‘tail’ of EM markets which appear to have over-borrowed in hard currency and could face challenges if yields remain elevated and the new issue market remains closed. Turkey is a key market to watch. While valuations in some cases overlook both the fiscal reforms EM governments are making and the support the IMF/other institutions are extending, investors will need to do their homework on a case-by-case basis.
Latin America has led the way in terms of orthodox policymaking this year, both within EM and on the global stage. Central banks in the region were the first to begin increasing interest rates and some of them are already through the hiking cycle; unlike many other bond markets, they are now trading to a different drum beat. We like Brazil in this regard, where the presidential election is also behind us, removing a lot of political uncertainty.
As for hard currency debt markets, with yields reaching levels not seen since the global financial crisis, we think there are plenty of attractively valued opportunities for investors to explore. We think Egypt has resilient fundamentals that the market is overlooking. It has secured significant support from the IMF, having done everything that was asked of it (including devaluing the currency). At 48 months long, we think the IMF programme speaks of the Fund’s confidence in the country’s debt sustainability, yet Egypt’s bonds are trading at very depressed prices.
For investors with US dollar denominated investments, 2022 was particularly tough. We expect the dollar’s relentless rise to come to an end at some point in 2023. An important catalyst for this will be the Fed coming to the end of its hiking cycle and US interest rates peaking. We are already seeing signs of inflation falling, which is a positive signal.
As the monetary policy action of the past 12 months starts to really take effect on economies in 2023, we will see growth slowing and recession risk rising across some markets. That said, if China does – as an increasing number of market participants are predicting – relax its zero-COVID policy stance, that could spur an economic recovery that reverberates globally.
More broadly, the starting point for 2023 is a lot more favourable from a valuation point of view after such a challenging year for the asset class.
General risks. All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.
Specific risks. Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.
With inflation surging for the first time in years, investment conditions have changed abruptly. Shifts in market regime can be perilous, but they can also present opportunities for nimble investors.
Explore our 2023 Investment Views, where our portfolio managers assess the outlook across their asset classes and regions.
Our team also takes a deep dive into the outlook for emerging markets, as well as into how sustainable investing will drive investment outcomes next year and beyond.