Yield opportunities in a challenged EM fixed-income universe

Can the head start in monetary-policy tightening by many emerging-market (EM) sovereigns, combined with strength among exporters and commodity producers, generate investment opportunities despite the headwind of US interest-rate hikes? We assess the opportunity set in the Q3 issue of Alphorum, our fixed-income quarterly. 

Fundamentals and macro

As we enter the second half of 2022, the macro environment is looking very challenging for EMs. The war in Ukraine has aggravated inflationary pressures and turned them into a lasting issue, while it is becoming more and more clear that we are also facing a growth shock. Indications that China is relaxing its zero-Covid policy represent something of a silver lining in this respect, but the country’s overall growth trajectory is still slowing this year. On top of all this, the aggressive tightening of developed-market (DM) monetary policy is increasing borrowing costs for EMs.

Fortunately, many EM countries reacted well to signals and started raising rates far earlier than their DM counterparts, while others caught up quickly. Even Asian countries, which until recently have suffered less inflationary pressure, have started to follow, although the region is still lagging and there remains a lot of repricing to do. Overall, though, aside from outliers such as Turkey, inflation is being kept at manageable levels. However, as long as the Federal Reserve (Fed) continues to hike, local rates will remain under pressure and are likely to remain elevated.

FIG 1. EM central banks’ rates may be close to peaking and are likely to remain elevated

Source: Bloomberg, Lombard Odier forecasts and calculations as at June 2022.

At the same time, broader economic policies, which have deteriorated due to the ongoing rise in populism globally over the past few years, is likely to weaken further as market conditions tighten and political pressures rise. The weight of food and fuel in consumer price index (CPI) baskets is much higher for EM than DM countries, so price rises represent a far stronger threat to social stability. Countries including Peru, Ecuador and Pakistan have already experienced protests, and more are likely elsewhere.

Sentiment

While there has been some stabilisation from the shock suffered across EMs, until investors can see an end to Fed rate hikes, sentiment will continue to be fragile. Foreign-investor outflows are likely to slow but will continue, with the impact felt more strongly in EM hard-currency markets, given foreign investors’ much stronger presence there compared to local-currency markets.

In this difficult environment, in our view net exporters with strong current accounts remain attractive – particularly energy exporters, who will continue to be able to raise US dollars via continuing demand even in the event of a global slowdown. In hard-currency markets, convexity is also appealing. A lot of EM countries issued bonds when US Treasury yields were very low and spreads tight, so coupons were tiny. As a consequence, countries in good shape that aren’t under stress have securities trading at very low prices in the secondary market, offering the potential for relatively low risk and strong upside for investors.

The much better relative quality of EM corporates compared to sovereigns is also worth noting – particularly those with strong savings and low leverage issuing bonds with shorter maturities.

Technicals

Technicals are broadly supportive for hard-currency bonds. As mentioned previously, the shorter duration and robust fundamentals of EM corporates are positive, while issuance is running low – at level not seen since 2016. As a result, we have cut our full-year 2022 supply forecast for EM corporate bonds by nearly 25%, from USD 525 billion to USD 400 bn. However, the global backdrop is unappealing for this market. Low supply is also supportive for ex-China local-currency bonds. However, countries are facing heavy refinancing needs and will need to address this at some point.

Valuation

For the hard-currency market, the silver lining is that spreads are making EM sovereign bonds quite attractive, in our view. The sovereign spread in the J.P. Morgan Emerging Markets Investment Grade Bond Index rose above 500bps at one point, meaning that average EM sovereigns were yielding 5% more than US Treasuries. Such a situation is not that uncommon, but never usually lasts for long. However, given the challenging situation for EMs, attractive spread levels may persist, presenting opportunities. In local- currency markets, yields are already turning positive in real terms for countries which entered the hiking cycle early.

Outlook

Looking forward, an improvement in the overall outlook for EMs will depend on two interrelated elements: the Fed relaxing its rate-hiking regime and inflation peaking. For countries like Brazil and Chile, which hiked early, that is likely to happen towards the end of Q3 2022, in our view. Others, particularly those in Eastern Europe, could have to wait until the final quarter of the year.

Asian countries may avoid high levels of inflation, partly thanks to price regulation and the lower weight of food and energy in CPI baskets. However, they are also likely to have to wait until later, perhaps early 2023, for it to peak. In the meantime, EM central banks have little choice but to continue to lift rates or at least to keep them elevated. Higher policy rates are a headwind for growth but should help anchor inflation expectations and enhance financial stability by reducing the risk of capital flight.

In terms of growth, our view is that a slowdown is inevitable across EM – the only question is how brutal it will be. This is difficult to price, but is already reflected by the market to some extent, particularly in currencies. In a worst-case scenario, this could herald a lasting period of stagflation.

This challenging global backdrop is a further barrier to the fiscal consolidation needed to improve the financial profile of most EM sovereigns, which have been severely weakened by the pandemic. As challenging conditions continue, net exporters will be better equipped to weather the storm, thanks to income from royalties and the ability to generate hard currency to pay debts. Those with improving current accounts and large yield differentials with DMs should outperform.

Brazil and South Africa should benefit from the commodities rally, offsetting their high indebtedness relative to other EM sovereigns. However, other fiscally weak EM nations – such as India, Turkey and Egypt – may struggle, particularly if they continue to delay issuance in an expensive market despite hefty refinancing needs.

To read the full Q3 issue of Alphorum, please use the download button provided.

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