Commodity dichotomy: diverging outlooks in emerging-market debt

The war in Ukraine and runaway commodity price inflation is creating a new duality within sovereign Emerging Market (EM) debt in which current accounts of net-commodity-exporters’ will improve considerably while that of manufacturing countries, which are net importers of commodities, deteriorate. At a time like this, what are the risks and opportunities for investors? This report is the third part of our latest quarterly assessment of global fixed-income markets, Alphorum. In our previous reports in this series, we explored what fixed-income scenarios could result from the current market shock, and what the central bank’s war on inflation means for developed-world bond markets. In the coming days, we will focus on insights into the dynamics driving corporate credit, sustainable fixed income and systematic research.

Fundamentals and macro

After a positive start to the year marked by strengthening currencies, strong commodities and improved sentiment towards the asset class, the war in Ukraine provoked a sharp turnaround for emerging market bonds. There was a shock to spreads in hard-currency markets, although beyond Russia, Ukraine and Belarus the contagion was limited to an average 50bps or so across the rest of the emerging markets (EM) universe. In the local-currency space, the index fell by around 7%, but this was mostly down to Russia with some limited contagion to Eastern European currencies. Asia and Latin America stayed solid, with the Brazilian Real actually outperforming. In general, EM corporate bonds have reacted slightly better than sovereign bonds, since they tend to be relatively shielded by low leverage, low duration and more robust fundamentals.

FIG 1. Eastern European spreads surged following the invasion of Ukraine but there was little contagion

Source: LOIM as at March 2022.

Perhaps more significant given Russia’s position as a key provider of energy, metals and grains, are concerns around commodity supplies. The war in Ukraine is a gamechanger for the global economic cycle since commodity-price increases are unlikely to abate in the foreseeable future. Overall, the effect is stagflationary and likely to weigh on EM growth, but there will be divergent consequences depending on countries’ exposures to commodities. This has created a new dynamic within the EM universe, in which net-commodity-exporters’ current accounts will improve considerably; in contrast, for manufacturing countries which are net importers of commodities, current accounts will deteriorate. With debt dynamics having stabilised at high debt levels in the wake of the pandemic, fiscal consolidation is needed, but will be difficult for commodity importers to carry through. At the same time, unchecked inflation in some EM countries could trigger social unrest as food prices rise.

Sentiment

Until the Russian invasion of Ukraine, EMs benefited from positive market sentiment. Valuations were perceived as attractive following last year’s underperformance, while investors looked favourably on the fact that many EM countries had responded to the inflation challenge with hawkish monetary policies ahead of developed markets.

The de facto default of Russian debt has weighed on sentiment towards the whole asset class to some extent, with the ensuing flight to quality resulting in risk reduction across EMs. In local rates markets, yields kept rising, although weakness was concentrated in countries perceived as having an unchecked inflation problem, including Colombia, Romania, Hungary and the Philippines. In contrast, Brazil, which is among the weaker EM countries in terms of debt dynamics, posted an impressive performance: investors were attracted by high local yields, its commodity-exporter status, a surprisingly calm political climate and the perception that an early start will soon bring Brazil’s hiking cycle to an end. Similarly indebted South Africa also has potential to benefit from the commodity rally, whereas commodity importers including Turkey, Egypt and Tunisia are at risk of a dangerous deterioration of their financial situation in the current context.

Technicals

For hard-currency bonds, positioning has decreased meaningfully, with the market looking a lot cleaner. Limited issuance is a supportive factor, but weakened companies and sovereigns risk getting into refinancing crises. Relatively sizeable outflows have been a feature since the beginning of the year. On the local side, there is still positive carry and roll-down for many EMs, but curves are bear flattening and are likely to continue doing so. Issuance was generally slow in Q1 but should accelerate, as financing needs are heavy.

Valuation

The market shock has brought renewed attractiveness across EMs. In the sovereign market, commodity producers have already outperformed and should continue to do so, while in corporate bonds ex-China, high-yield spreads are especially attractive. Meanwhile, well-supported local-currency Chinese government debt continues to be an attractive diversifier thanks to its low (though positive) correlation with rates in developed markets, although the yield differential against US Treasuries has fallen sharply. Most other local EMs should benefit from high FX carry and significant yield differentials when compared to the main economies. 

Outlook

The main macro risk ahead for EMs is even higher inflation, coupled with a terms-of-trade shock for non-commodity exporters (the evolution of the war in Ukraine will be crucial in this respect). With commodity prices adding inflationary pressure, it is now almost certain that the peak of the inflation cycle will be delayed until at least the second half of the year for most countries, and that growth, on average, will be lower. Nevertheless, commodity-exporting countries will be in a much better position than manufacturing countries, as better terms of trade will support external balances, economic growth, and fiscal accounts. That will tend to make things more difficult in local-currency bonds, since it is more a universe of manufacturers (with Brazil, South Africa, Chile, and Colombia being notable exceptions). Of course, some net importers will be better positioned than others, with those starting from a position of lower inflation, higher reserves, and healthy fiscal accounts better equipped to weather the shock.

Many EM central banks were doing a good job of containing inflation prior to the latest market shock. They are unlikely to change course, preferring to focus on preserving financial stability despite the risk to growth. This mitigates to a certain extent the risk of inertia and second-hand effects, whereby sharp rises in food and energy costs potentially contaminate other prices. 

The biggest challenge in Latin America continues to be political risk. Brazil has elections in September, with neither incumbent nor challenger likely to show fiscal restraint. Colombia holds elections from May, with a very leftist candidate leading. Peru continues to suffer from political instability, while a new constitution in Chile could be problematic.

Solid strategic demand for Chinese bonds is likely to continue amid the search for quality yield, so long as the Chinese government continues to tread a prudent diplomatic line. Sanctions on China would have negative consequences for the West, while China itself is focused on growth and will not want to disrupt its exports. However, US-China trade tensions could re-emerge, particularly if China steps up its territorial claim on Taiwan.

Overall, attractive valuations should continue to support the market once current uncertainties diminish, in our opinion.

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