Regime shifts in EM amid dual shocks

We are now dealing with two significant shocks to the global economy in the form of a global growth reset and a commodity reset. While developed markets have responded to the COVID-19 crisis with a sharp monetary and fiscal easing, for most emerging market (EM) countries, such a response will be tricky. They are faced with more difficult debt sustainability and external financing dependencies that will force fiscal prudence and hamper the effectiveness of the government’s response.

It is noteworthy that EM largely escaped the 2009 Global Financial Crisis in a relatively unscathed manner. Debt levels were much lower, and China turned into aggressive growth mode. Commodities experienced a sharp bounce as a result, and the rising tide buoyed all commodity-heavy EM credits. We think this time is different though. China’s response so far has been measured and internally focussed. Even with a short-lived crisis, balance sheet stresses for EM will indeed be very real for some time to come. Brazil’s (BB-rated) fiscal package to counter coronavirus, for example, is expected to add 10pp to its debt (to 86% public debt/GDP) in just this year. How their debt sustainability will evolve when we emerge is likely to weigh significantly on its rating trajectory. Many EM countries find themselves in a similar situation. As a result, a highly selective approach to EM investing is required.

We showcase our approach to top-down investing in this latest paper through 5 sections:

1. Sovereign Creditworthiness Framework where we summarize our 4-tiered approach to evaluating sovereigns
2. Overview of our Country Views where we assess the impact of the dual shocks across 30 sovereigns in our universe
3. Assessment of rating downgrades where we quantify the credit ratings trajectory on a 1 year and 3 year horizon
4. Spotlight on India
5. Spotlight on Indonesia

As we elaborate upon in the various sections, EM will not emerge unscathed from this crisis as the balance sheet damage even from a transient shock could still be significant. Our key takeaways are as below:

• Larger EM countries with a) deep domestic markets, b) high potential growth and c) significant fiscal space/low debt burdens will emerge as winners. China will be a major beneficiary given its strong public sector enterprises and its ability to internally fund itself through its domestic markets. India will continue to benefit from a consistent funding base territory thanks to high domestic savings rates and potential growth. Indonesia has ample fiscal space and much-strengthened institutions that could offset their shallow domestic markets. Similarly, we expect countries such as Mexico and Turkey to muddle along.

• Frontier economies will clearly bear the brunt of the stress, and face a potential loss of investibility. Unlike some market participants, we do not expect the IMF to emerge as a savior for private creditors and countries alike. They are still and will be bound by debt sustainability metrics for their program lending, and even with very liberal assumptions, the damage to some EM countries will become too big to ignore without private sector participation in restructuring.

• Ratings upgrade trajectories for a lot of EM countries will be challenged. Brazil’s debt increase, even if a one-off, will severely constrain its trajectory back into Investment grade territory. The positive outlook from S&P on Japan that stemmed from fiscal reform efforts is unlikely to translate into rating upgrades given the extent of policy response that will be required to the Covid-19 shock. Commodity-exporting economies will also face questions around fiscal sustainability and future growth prospects, and will likely come under pressure too.

• Investment Grade Asia has significant policy buffers to withstand the global demand shock. Asia, for the most part, is less exposed to lower commodity prices (and in fact stands to gain from them), and so has the luxury of only having to handle one shock instead of two. The region has also built up sizeable policy buffers over the years and so is able to respond more proactively to protect its economies.

We also cover the fundamental story in great depth without addressing the valuations at all. The valuation overlay is undoubtedly cheap, and can form a great entry point for investors that take a selective, disciplined approach to investing in Emerging Markets. Given the large flux in the system, investors should consider building portfolios that allow rating migrations to happen as long as mitigating conditions (as outlined above) remain in place.