Emerging markets debt: brighter prospects ahead as the storm passes

The Emerging Markets Debt Hard Currency (EMDHC) team considers four key factors when assessing the outlook. In the near-term, the uncertain global macro environment is the key factor that is driving the outlook and trajectory for the asset class in the remainder of 2023, but we expect to see more positive flow dynamics over the medium term on the back of a widening economic growth differential between emerging markets (EM) and developed markets (DM). Currently, there is also considerable spread dispersion within the EMDHC asset class, which represents an opportunity for active investors.¹

The never-landing US and China’s cyclical recovery

Developed markets are expected to lead the global growth slowdown, while emerging markets remain relatively resilient. The International Monetary Fund (IMF) projects that growth across advanced economies will slow from 2.7% in 2022 to 1.5% in 2023 and 1.4% in 2024, with the US seeing growth slow from 2.1% in 2022 to 1.8% in 2023 and 1.0% in 2024. Conversely, EM and developing economies are expected to expand 4.0% in 2023 – in line with the 4% figure for 2022 – and rise to 4.1% in 2024.² Within the EM space, developing Asia is a particularly bright spot, expected to post growth rates of 5.3% in 2023 and 5% in 2024, according to the IMF, but this is dependent on speed of the China recovery. It is also important to remember that the investible universe includes frontier countries with growth rates in the mid-to-high single digits.

In the US, leading indicators still point to a significant recession risk, though hard data has been more resilient, including the labour market. Moreover, significant progress has been seen on the inflation front, with CPI inflation falling to 3.0% for the 12 months to June 2023; the smallest

12-month increase since the period ending March 2021.³ Estimates suggest core inflation may average 2.5% annualised in the second half, and it is less likely that we will see further hawkish repricing with the growing disinflationary trend in place. This should be supportive for EM, paving the way for less policy-related uncertainty as both rates and the US dollar are past their peak.

In our view, market pricing is too optimistic on US growth scenarios and the adjustment to a recession will dampen risk appetite as the Federal Reserve (Fed) is unlikely to step in as quickly to pivot monetary policy as in recent slowdowns. We believe the late-cycle environment will likely keep volatility elevated and data dependency high. However, as inflation comes down, Fed policy ammunition grows and consequently the risk of a harder landing declines. Hence, the negative scenario of a hard landing is time sensitive.

In China, sequential growth has likely already peaked. To date, the recovery is mainly service-driven and state-led and the global slowdown is dampening exports. A broadening out of the recovery depends on Chinese consumers turning less pessimistic. However, the property market slump has hurt confidence, while elevated youth unemployment and an unwillingness among households to spend their savings remain headwinds. We expect the Chinese authorities to remain path-dependent to ensure growth targets are met. This implies the use of more targeted fiscal policies (eg. property). On that basis, we conclude that the positive spill-over effects of China’s recovery on other EM countries will be more muted than in the past.

Figure 1 shows on a regional basis the degree to which economic data and inflation has surprised relative to market expectations since the start of 2023. In China, we have seen disappointment on growth but inflation that has been lower than expected (CPI is now following PPI into deflationary territory). Growth in Latin America has been very resilient, significantly beating expectations so far this year. To us, this suggests we should not get too bearish on China going forward as negative surprises are already at historical highs.

Our base case is that the divergence in economic growth between EM and DM is shifting significantly higher. This is illustrated in Figure 2, which shows the widening disparity in forecasted global growth dynamics. An improving EM-DM differential has historically signalled stronger relative performance.

The EM fundamental outlook is holding up

Despite the headlines, many emerging markets remain relatively robust, with progress on fiscal consolidation and improving debt metrics. Relatively strong real GDP growth overall for countries in the benchmark JP Morgan Emerging Market Bond Index Global Diversified (EMBIGD) universe is highlighted in Figure 3.⁴ Also positive for EM countries, they have ample scope for monetary policy easing due to the higher starting point for real rates and improving inflation dynamics. EM inflation is falling, as evidenced by global supply chain normalisation and weakening PPI – most notably in China. EM central banks were early into the rate hiking cycle relative to the rest of the world – inflation is now falling and a number of these central banks are now closer to start cutting rates (eg. Brazil, Mexico), providing a buffer – although this is not universal. The policy response in EM to rising inflation, in our view, solidifies EM policy credibility.

Credit quality in EM, overall, has stabilised, but a slowing global economy does weigh on EM as many are dependent on international trade and overall credit quality is under some modest downward pressure. The slowdown is putting pressure on fundamental credit metrics; in some sense the resilience seen in the first half of 2023 is front-loading, meaning the second half of the year could disappoint.

Within our overall ratings outlook, there are key differences between higher-rated and lower-rated countries. Weaker countries face various headwinds – slowing growth, elevated funding costs and lack of market access – and this is reflected in our average ratings outlook by credit segment.

Several distressed countries are going through restructurings or are trying to avoid defaults by making policy adjustments, often supported by the IMF. As time is critical in restructurings, slow progress (or lack of it) has weighed on market pricing for the most of the first half. Recently, a flurry of constructive news has lifted sentiment, including a debt restructuring agreement between official creditors and Zambia; approval of an IMF-program for Pakistan; and progress on local debt restructurings in Ghana and Sri Lanka. While there is still a long road ahead before these countries can regain market access, recent progress bodes well for future restructuring processes. The risk of broader contagion from distressed countries to the broader emerging markets asset class is, in our view, limited.

‘Core’ EMD spreads now fairly valued

Current credit spread valuations are perhaps the most difficult area to unpick due to the continued bifurcation of the market. It is mainly lower rated single B and CCC-rated issuers that offer wider spreads, both relative to long-term history and when comparing emerging market US dollar sovereign debt to US corporate credit. Those in the investment grade portion are below their historical averages.

Another way to look at it is shown in Figure 4, which suggests that current market spreads are not far from fair value. Of course, the universe of 70 countries is broader than that the 12 ‘core’ countries included here, but it is a reasonable barometer at the top level.  It is important to bear in mind that this assessment (and EM spreads themselves) are a function of risk aversion/volatility, which has fallen significantly year-to-date. Given the uncertain macro environment in developed markets, it is hard to discount that we will not see higher levels of risk aversion in the second half (our current risk aversion indicator, which is an input to the valuation model, is now below median levels). That leaves us a little more cautious in our credit risk positioning compared to earlier in the year, but not underweight.

However, as is the case with other fixed income asset classes, the repricing of treasury yields over the last 12 months has dramatically improved the prospective returns for investors in the asset class. Whether you look at the whole universe or exclude CCCs, the current index yields are in the top quartile, looking at the last 20 years.⁵

We also note that the bifurcation of the market can create opportunities within the asset class. Within the EMDHC universe, as represented by the JP Morgan Emerging Market Bond Index Global Diversified (EMBIGD), standard deviations have risen to an all-time high (Figure 5). This dispersion indicates that the asset class has matured: its constituents are no longer behaving as uniformly as in the past, the number of countries in the universe has broadened out and there are more idiosyncratic stories that an active, bottom-up, analytical investment approach can exploit.

Our focus is on the medium-term trend of sovereign credit risk (as reflected in ratings), which in tandem with current valuations leaves us favouring the high yield portion of the universe, including Uzbekistan, Gabon, Mozambique and Benin, whilst having less exposure to some of the larger issuers in Latin America and Asia.

Footnotes

¹ In statistics, the word dispersion is used as a measure of how spread out the underlying data is. In this instance, we are referring to dispersion in credit spreads.

² Source: IMF World Economic Outlook as at 25 July 2023.

³ Source: U.S. Bureau of Labor Statistics, as at 12 July 2023. Figures are before seasonal adjustment.

⁴ The JP Morgan Emerging Market Bond Index Global Diversified (EMBIGD) is a uniquely weighted USD-denominated emerging markets sovereign index. According to JP Morgan, the EMBIGD is the most widely followed USD EM sovereign index.

⁵ CCCs refer to bonds rated CCC by a credit rating agency. Credit ratings refer to the assessment by a credit rating agency as to the creditworthiness of the entity issuing the bond – in other words, the ability of the issuing entity to meet its financial obligations, including its bond payments. Bonds rated CCC are considered speculative, or non-investment grade.

IMPORTANT INFORMATION

Emerging market investments have historically been subject to significant gains and/or losses. As such, returns may be subject to volatility.

High-yield or “junk bonds” involve a greater risk of default and price volatility and can experience sudden and sharp price swings.

The JP Morgan Emerging Market Bond Index Global Diversified (EMBIGD) is a uniquely weighted USD-denominated emerging markets sovereign index. It tracks liquid, US dollar emerging market fixed and floating- rate debt instruments issued by sovereign and quasi sovereign entities.