Asian credit: repositioning in EM debt

 

Asia’s macro resilience over EM calls for long-term repositioning

We believe Russia’s invasion of the Ukraine in February 2022 has redrawn the geopolitical landscape for years to come. Sanctions against Russia have had significant ramifications for debt investors, due to the Russian assets becoming uninvestable as a result.

Within emerging market (EM) debt, Russian and Belarussian securities have been removed from major indices as at 31 March 2022, including JP Morgan’s EM credit indices, such as EMBI and CEMBI. The effective writedown of Russian assets has been significant: prior to the war, as at 31 December 2021, Russia constituted an approximate 5% weight across corporate EM credit indices (such as JPM CEMBI) and 10% in the sovereign-only USD JPM GBI EM Diversified index. 

This tail event for EM follows several years of weakening EM sovereign debt metrics since 2013-2014, and exacerbates deterioration spurred by the Covid-19 crisis. Since the 2020 pandemic, various EM countries have faced further fiscal pressures, an unfavourable growth-inflation mix and higher debt levels leading to sovereign rating downgrades. A range of EM countries have lost their investment-grade (IG) status over the past decade, including Brazil, Russia, Turkey and South Africa.

In the midst of this, Asia has remained relatively resilient from a macro perspective given the region’s strong fiscal buffers and its ability to absorb inflation and move forward with a reasonable annual growth rate of around 5%.

Given these developments, we believe there are important longer-term consequences for EM investors:

• The CIS/CEE¹ region is largely un-investable
  • Due to sanctions on Russia and Belarus and removal from indices
  • Ukraine remains at war and the remaining CIS/CEE region will remain challenged (especially pro-Russian central European states)

• Dispersion is rising exponentially
  • We see increasing restructuring risk in net commodity-importing, high-yield (HY) rated EM countries. This is due to high inflation, tight external financing markets and resulting credit deterioration
  • Turkey, Egypt and selected African states face an unfavourable inflation and growth mix
  • There will be new potential default candidates such as Sri Lanka, Zambia, Kenya and Ghana
  • Political risk is increasing in major Latin American markets such as Brazil, Chile and Peru
  • IG sovereigns with strong fiscal buffers and commodity exporters are best placed to manage the shifting inflation-growth environment

• EM debt indices could become increasingly barbelled
  • EM sovereign indices are progressively diverging: on one side stand deteriorating credits with widening spreads and new default candidates; on the other side stand much tighter (ie. expensive) credits supported by higher commodity prices
  • Commodity-exporting IG sovereigns with strong fiscal positions stand to benefit. This includes longer-dated bonds that are trading tight in yield and spread relative to US Treasuries
  • Sub-investment grade sovereigns (especially lower rated nations, including single Bs) face downgrade and restructuring risks
     

Which Asian economies stand to weather inflation better?

As prices rise globally, the ability to withstand inflationary pressures is key. According to our assessment, the countries and regions shown in figure 1 should be better placed in the medium to long term to absorb inflation. This is due to their stronger FX reserves, reasonable growth buffers, large domestic markets and strong institutional frameworks. As such, they have significantly lower long-term downgrade risks, in our view.

 

FIG 1. Sovereign likely to be more resilient to inflation

Country/region	Inflationary impact and mitigants
China	Major oil importer. Manageable impact on current account surplus from higher oil prices Sufficient fiscal buffers provide an ability to focus on improving growth even amid Covid and the property-sector slowdown
India	Higher oil prices will pressure its current account deficit and ability to pass through higher inflation. However, the government stopped subsidising fuel for consumers and businesses in 2015 Increasing and aggressive programme for renewable energy development Progressive and prudent budget for fiscal programs to lead growth via increasing capex cycles
Indonesia	Key beneficiary of higher commodity and energy prices. Net exporter of many commodities Strong external buffers (FX reserves) and resilient domestic growth drivers
Thailand	Strong fiscal and external buffers Continues to be a manufacturing and automotive hub for the ASEAN region Net importer of oil but runs small current account surpluses
Malaysia	Net commodity exporter and hence beneficiary of higher energy prices Diverse economy with strong manufacturing output, but with marginally weakening fiscal metrics
Developed Asia (commodity importers)	Korea, Taiwan, Singapore, Hong Kong and Japan have strong buffers to counter cyclical inflationary shocks
Australia	Strong AAA-rated and diversified economy with a commodity tailwind
Middle East	Benefits from sustained higher commodity prices and accelerated reform programmes and growth momentum in countries such as Saudi Arabia, Oman, UAE and Qatar.

Source: LOIM. For illustrative purposes only.

 

In light of these factors, we believe investors allocating to EM debt should reposition by:

1. Becoming more selective within EM debt. We believe that there will be greater need for customised and bespoke investment approaches within the broader EM universe to avoid structurally challenged parts of the market.
2. Moving away from increasingly barbelled EM indices. There is a need to shift away from indices that were more homogenous in their composition years ago but are becoming more barbelled, such as the EMBI sovereign hard-currency universe. EMBI used to be rated IG but is now HY and is increasingly a site of downward ratings migration. We believe investors would benefit from clearly defining their Asian and EM IG allocations as well as selected HY allocations for both sovereigns and corporates.
3. Positioning Asia-Pacific as the core of EM allocations. The Asia-Pacific region, as well as the GCC² countries, have more robust macroeconomic buffers and their debt sustainability should be much more resilient as Asia continues to be the centre of growth and demand.

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