Key drivers in emerging-market debt

We discuss key drivers in emerging bond markets as part of our latest quarterly assessment of global fixed income, Alphorum. Having already considered corporate credit and sovereign developed markets, in the coming days commentaries on sustainable fixed income and systematic research will follow.

Fundamentals and macro

Forecasts for emerging markets (EMs) in 2022 are reasonably positive. Most EM countries are still in recovery-led growth and while this will slow, 2022 should still see average EM GDP growth of 4.5-5%, in our view. Meanwhile, (ad-mittedly high) inflation is expected to peak in the first quarter and then start to come down.
Despite this, uncertainty is weighing heavily on EMs. With almost all releases showing an acceleration in prices for goods and services, the potential for inflation to become sticky and cause second-round effects remains a real con-cern. For many EM countries, particularly in the Middle East, North Africa and Latin America, rapidly rising food prices are a particular issue, as these could feed back into the socio-political situation.

At the same time, the resurgence of acute Covid-19 uncertainty caused by the emergence of the Omicron strain has further impacted EM growth prospects, which were already dented by the likelihood of a Chinese slowdown. Added to this, the outlook for investment is poor — one reason for this is that the difference in the pace of growth between EM and developed markets is narrowing, leading to a slowing of capital flows to EM. 

Political uncertainty is also rising. In Latin America, 2022 will see elections in both Brazil and Colombia, while changes to the constitution in Chile are also viewed with unease. Elsewhere, geopolitical issues, particularly China-US tensions over Taiwan but also Russia’s stance towards Ukraine, increase uncertainty around emerging market growth. And all of this comes on top of tightening monetary policy in the US, which will inevitably put further pressure on emerging markets.

Sentiment

Genuine concerns about the challenges facing EM countries explain the harsh sell-off and poor sentiment towards the asset class over the closing months of 2021. Concerns around the rising impact of Omicron have added to negative sentiment provoked by the ongoing issues in China and resulted in continuing outflows, particularly from Asia.

Despite intervention by the authorities, Chinese real estate developers continue to struggle to service their debts amid a significant slowdown in property sales. Meanwhile, Turkey’s underperformance continues to accelerate, exacerbated by President Erdogan’s refusal to raise interest rates despite a rapidly depreciating lira, rampant inflation and deteriorating living conditions. Inflation is also an issue in Poland and Hungary, where central bank action has been deemed insufficient by markets, leading to massive repricing of curves. And Russia also underperformed in the final quarter of 2021, buffeted by falling oil and gas prices and tensions around Ukraine.

More positively, Brazil recovered from excessive inflationary expectations to outperform in late 2021. Brazil is among a number of EM countries including Hungary, Mexico, Peru and Russia that have responded to rising inflation by hiking rates accordingly, which may have helped investor sentiment. Most Eastern European central banks were perceived as acting behind the curve for the better part of 2021 but are now trying to catch up, with Poland, Romania and the Czech Republic all announcing larger than expected rate hikes as the year drew to a close. South Africa also posted a first hike, but with inflation so far muted in Asia due to large output gaps, most Asian EMs have resisted the trend. Higher policy rates are a headwind for growth, but should help anchor inflation expectations and reduce the risk of capital flight.

Technicals

At USD109 bn, net financing for EM hard currency bond markets (corporates and sovereigns) in 2021 was much lower than in 2020 (when the figure was USD181 bn)¹. Net financing should continue to diminish in 2022 with USD 19bn expected for sovereigns and only USD 3bn for corporates, which should be supportive for bond prices. For local bonds, supply is expected to remain heavy but still below the highs of 2020.

Positioning is also becoming more attractive as investors have substantially de-risked their portfolios in 2021 in the EM hard currency space and have substantially reduced their exposure to EM local currency debt, where ownership is at a four-year low.

Figure 1. EM corporate net financing forecast to come down to minimal level in 2022

Source: JP Morgan. Refers to hard currency debt in EM corporates/ LOIM estimates.

Valuation

Total returns for credit were put under pressure in 2021, due to rising rates even as spreads became tighter. However, EM corporates have been holding up relatively better. Spreads for the J.P. Morgan CEMBI Broad Index peaked recently, marking the highest levels since early December 2020 — although this was driven entirely by Chinese corporates. EM sovereign hard currency debt also had a difficult 2021, suffering a spread widening of roughly 20bps which has marginally increased its attractiveness.

On the local currency side, the harsh sell-off suffered in 2021 has markedly improved valuations. EM nominal and real yields are now very attractive versus their developed market counterparts, while FX carry has risen sharply, providing a substantial compensation for EMFX positions.

Outlook

As the global recovery unfolds, plenty of issues cloud the horizon for EM bonds. Slowing growth and a narrowing of the EM/DM growth differential, the potential impact of persistent inflation, and the return of Covid-driven uncertainty are all cause for concern. At the same time, a rapid withdrawal of monetary support in developed countries is a headwind for EM which could prove noticeably detrimental to capital flows. The pandemic has also significantly and meaningfully increased public indebtedness across EMs. Although debt levels are mostly not disproportionate compared with developed market countries, fiscal consolidation is needed in Brazil and South Africa to stabilise their debt dynamics — the way Brazil’s fiscal policy debate is evolving is therefore of particular concern.

For China, despite the ongoing real estate saga, data indicates the economy is reasonably resilient (and for now still export led). The Chinese government has intervened where necessary through 2021, providing liquidity to the market. Meanwhile, the value of the Renminbi has appreciated significantly, staying roughly aligned with the US dollar. This is positive in terms of the Chinese government’s desire to rebalance towards domestic consumption, but could see China losing competitiveness in export markets, particularly against other EM countries. If the export sector starts to feel the pain, the government may intervene in foreign exchange policy to tame the renminbi. We see this as an important risk to be aware of, but expect any measures to be proportionate and unlikely to result in a major sell-off.  

Despite these issues, there are reasons to be positive about emerging market debt. EM countries continue to benefit from supportive lending programs and still-low rates in developed markets. We also see the shorter duration and robust fundamentals of EM corporates as supportive to keeping the EM universe more resilient against higher rates. We therefore maintain an overall overweight view for EM with a preference for hard-currency debt, which is less sensitive to ongoing inflationary pressures.

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