Liquidity, uneven recoveries and debt sustainability: The outlook for emerging-market debt in 2021

Liam Spillane, head of emerging market debt at Aviva Investors, picks three themes that could have a big say in how the asset class performs in 2021.

Liquidity, uneven recoveries and debt sustainability: The outlook for emerging-market debt in 2021

1. Emerging debt markets look to be on course to deliver positive returns in 2020 after the year got off to a shaky start. Central banks’ ongoing provision of huge amounts of liquidity is cause for cautious optimism this trend will continue.

Around the world, central banks have bought record amounts of bonds and other assets as part of the response to COVID-19, in the process injecting record amounts of liquidity into financial markets. Emerging nations, where central banks have in some instances deployed quantitative easing and unconventional policies for the first time in many years, have been no exception.

Global demand for EMD has been strong

As a result, investors around the world are flush with cash. With fixed-income assets in developed markets offering low prospective returns, global demand for emerging-market debt (EMD) particularly hard-currency sovereign bonds, has been strong,

While the deployment of vaccines holds out the prospect of more buoyant economic conditions in 2021, central banks are likely to be wary of tightening monetary policy in a hurry. This should continue to underpin demand for higher-yielding assets such as EMD, not least given its ability to offer genuine portfolio diversification.

2. The coronavirus outbreak has had a very different impact on emerging nations’ economies. In general, Asian states have coped relatively well, while others, most notably in Latin America, have been hit far harder.

The economic picture for 2021 looks somewhat brighter, although investors, as ever, need to be aware EMD is not a homogenous asset class. Whereas some countries are likely to emerge from the pandemic relatively unscathed over time, others have been gravely affected.

Hard-currency EMD outperformed local-currency debt by a wide margin in 2020

The rapid deterioration in the economic environment led to emerging nations’ currencies depreciating sharply. This helps explain why hard-currency EMD outperformed local-currency debt by a wide margin in 2020.

We still favour hard currency debt. However, local currency debt could begin to look increasingly attractive if the global economic backdrop improves faster than we currently expect, for example following the roll-out of vaccines.

3. The glut of global liquidity enabled emerging countries to implement monetary and fiscal policies that were extraordinary in both scale and implementation. However, there is now a notable risk for some EM economies that as the world begins to return to some form of normality, the sustainability of many of these policies starts to be questioned.

The market has so far given emerging countries the benefit of the doubt because the world has been flooded with liquidity. The risk for some is that, as and when central banks start to turn off the taps, the tide begins to go out.

Yields in developed bond markets remain extremely low. Should the deployment of vaccines lead to a stronger economic recovery, it is likely we will see developed market yields rising. In that environment we would expect to see EMD investors become much more discerning.

Worries over emerging countries’ longer-term growth prospects are likely to persist

Many emerging countries have been experiencing weaker economic growth for a decade prior to Covid-19 after international trade plateaued and they failed to implement structural reforms. While vaccines may lead to a decent economic rebound in 2021, worries over emerging countries’ longer-term growth prospects are likely to persist.

That makes it more probable investors will at some point begin to question the ability of some countries to get government debt, which has ballooned in 2020, back under control. The sustainability of monetary policy could also be called into question.

In summary

Within financial markets, nowhere are the seismic changes brought about by the coronavirus pandemic more evident than in emerging markets. The provision of unprecedented levels of support by both central banks and governments has helped stabilise markets.

Even with vaccines offering the prospect of economic recovery, that support seems unlikely to be withdrawn in a hurry. For now, that could encourage further risk taking, perhaps leading local-currency debt to outperform. However, investors are walking a tightrope. They need to be mindful of the long-lasting damage that has been done to many countries’ finances and on the lookout for any signs central banks may withdraw liquidity sooner than expected.

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