Jun 28, 2022
Since the start of the year, we have been in a bond bear market with yields rising and credit spreads widening. While quantitative tightening and rate hikes have been key drivers, the war in Ukraine has exacerbated matters, not least by increasing inflationary pressure via food and energy prices.
Despite all this, EM assets – excluding Russia, Ukraine and the underlying US asset price effects – have held up really well, with EM currencies outperforming G10 currencies. This reflects fundamental strength in many EM economies and the conservative approach of EM central banks, which moved decisively to tackle high inflation.
Rather than let real policy rates fall as inflation advanced, over the past year central banks across emerging markets have acted much more prudently than their developed market peers by swiftly hiking. In aggregate, emerging markets are now running real policy rates well above their pre-COVID levels. In contrast to the US and other developed market economies, much of the pain of rate hiking is already behind many emerging markets. Coupled with the fact that we believe food and fuel inflation should moderate into year-end 2022 as the base effects of pre-crisis commodity price increases come through, we think this puts most EM economies on more favorable footing than developed markets. Historically, EM currency performance has been closely tied in with commodity cycles.
Widespread weakness in current account balances was a key factor in the 2013 taper tantrum; today’s situation stands in stark contrast. Terms of trade (average export prices minus import prices) across the EM universe have been very strong, allowing emerging markets to run large current account surpluses for some time. This proved to be helpful for monetary policymakers as they responded to COVID, allowing them to cut interest rates without worrying too much about the negative impact on exchange rates. As developed markets began to reopen in 2020/2021, the surge in demand for EM exports gave further support to current account balances, with sluggish imports helping drive trade surpluses higher. The result is that emerging markets are now net lenders of US dollars to the rest of the world, making them more resilient to the negative effect on their exchange rates of US interest rate hikes. In effect, emerging markets in the main have built sizeable buffers.
The surge in commodity prices is widening the gap between commodity exporters and importers, with some emerging markets benefitting significantly.
An increased focus on energy security is likely to further boost a range of EM energy exporters, as well as exporters of materials needed for renewable energy, for example. As for energy importers and other less fiscally robust economies, the allocation of special drawing rights from the IMF has substantially alleviated funding requirements in many markets. Furthermore, some energy importers (e.g., in Central and Eastern Europe and Asia) have very strong long term productivity gains, balance sheets and external positions and, therefore, should see their assets remain resilient, despite the higher import costs.
Despite recent moves higher in US yields, the EM yield differential is still sizable, making the EM debt market a rich hunting ground for active investors, particularly given its inherent inefficiency. In the major EM bond indices, nominal yields range from 6.4% (corporate) to 7.5% (sovereign), which compares with a 3.0% yield on US sovereign debt, as at the end of May 2022. The difference in real yields is also stark, with a negative reading (-0.09%) in the US compared with 2.41% for the main EM local bond index.
Just one part of the overall investment universe, EM corporate external debt, has grown to over US$2.7 trillion*, making it a larger market than US high yield. Consequently, it is getting much more attention from global asset allocators, who recognize the spread premium for comparable credit quality, among other attributes.
While the backdrop of war in Ukraine and rising inflationary pressure saw the IMF revise down its growth forecasts for this year and next as we noted here, growth in emerging markets continues to outpace that of developed economies – with the gap expected to widen significantly in favor of emerging markets next year. The IMF’s latest World Economic Outlook forecasts growth of 3.7% for the US this year and 2.3% for 2023. This compares with 3.8% in 2022 and 4.4% in 2023 for emerging market and developing economies, though with significant dispersion within them. Excluding Russia, the IMF’s EM growth forecasts for 2022 range from 0.8% for Brazil to 8.2% for India.
Furthermore, cyclical dynamics are set to favor emerging markets relative to their developed peers. As the US withdraws the exceptional fiscal and monetary policy stimulus/support measures and its economic growth outlook weakens, we expect to see EM growth assets outperforming their developed counterparts. However, in bottom-up selection decisions, it is important to distinguish between structural and cyclical drivers. For example, the consistent productivity gains seen in Asia and Central & Eastern Europe fall into the structural category, while current commodity price-related fiscal strength seen in Latin America and the Middle East & Africa is likely more cyclical in nature. That said, energy and commodity market trends may well be moving into the realm of structural shifts when you consider the global transition to a net-zero world.
Emerging markets will be crucial in the global shift to net zero. Not only does the emerging world account for most of the growth in emissions, it also supplies many of the commodities required to build a greener future. Moreover, one of the main reasons emissions have fallen in the West is that multinationals have outsourced the production of goods consumed in the developed world (and effectively their emissions) to the East.
Consequently, achieving a global net zero requires significantly more investment in emerging markets. This is likely to create new avenues of growth, and hence investment opportunities, in the developing world.
For more on this topic, please see a paper we published at the end of last year.
Considering the EM debt asset class overall, whether you look at local, EMFX or hard currency, EM assets are cheap relative to history and to their developed market peers. Current valuations suggest that mild recession is already priced and that a hard recession (although not our base case) is not far off being priced. This suggests we could be close to an attractive entry point already; a turn in the inflation tide or another 100bps of spread widening are the triggers we are currently watching for.
However, the war in Ukraine and its implications for inflation and growth have complicated the landscape for the US Federal Reserve and, consequently, for emerging markets. The peak in inflation has been pushed higher and further out, and the downside risks to global growth have been exacerbated. Our in-depth work on inflation and hiking cycles has made us relatively cautious from a top-down perspective. We are neutrally positioned across local rates, EMFX and hard currency debt, preferring bottom-up selection in a complex global environment, which we see as having distinct winners and losers.
Across EMFX (neutral top-down target), while commodity price strength, market positioning and the interest rate differential vs. developed markets are all helping the asset class, there has some recent deterioration in EMs’ terms of trade as oil prices are moderating on recession fears.
We are cautious on the Indian rupee; India is very exposed to oil through inflation, growth, and the fiscal and current account. In contrast, we like the Singapore dollar as we believe Singapore’s central bank will continue to tighten policy given high inflation and a tight labor market. We have a negative view on the Philippine peso as the terms of trade are deteriorating in the country.
In hard currency debt (neutral top-down positioning), rising US rates and dissipating liquidity are keeping us cautious. Within an increasingly divergent investment universe, we currently like debt issued by some Gulf Cooperation Council countries, which are benefiting from high oil prices. We also like Angolan debt on strong fundamentals (including a large current account surplus). Egypt is also attractive from a debt sustainability (and valuation) perspective, given positive dynamics in terms of multilateral support and an IMF program, with fiscal prudence continuing in the country. In contrast, we have a more cautious view on the Dominican Republic, given the negative impact of sustained high oil prices, a slight fall in tourist arrivals and the likelihood of more issuance to fund increases in energy and food subsidies.
Beyond the sovereign space, there is a wide array of opportunities in today’s EM corporate credit markets across the credit rating spectrum, particularly following the recent sell-off. We are selectively pursuing opportunities in all areas of the market. Turmoil in China’s real-estate sector has also created extremely low valuations in some high-quality firms that we think should benefit significantly from positive policy shifts.
As for hedged local currency bond markets (local rates), our neutral top-down positioning reflects the fact that although the weak growth outlook is favorable for bond prices, inflation remains elevated across most of our investment universe.
In Central and Eastern Europe, we think relative value favors Czechia given it is closer to the end of the rate hiking cycle, whereas in Poland we think the central bank will be reluctantly forced to keep hiking rates for some time to come given pro-inflationary fiscal policies and high wage growth. China is one of the only markets able to ease policy and perform as a store of value in fixed income. We also like South African local bonds; budget execution has been better than expected and inflation is behaving well compared to most other EM countries, with valuations also relatively attractive.
This is not a buy, sell or hold recommendation for any particular security.
*Source: JP Morgan, as at 31 March 2022
Emerging market: 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.
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