Aaron Grehan and Nafez Zouk from our emerging market debt team explain how the asset class is standing up to some significant headwinds.
Read this article to understand:
- Why the current issues facing emerging markets are global in nature, including rising rates and inflation
- Why the policy response by China will have a big influence on the performance of other emerging markets
- How the wide sell-off in financial markets is presenting opportunities for EMD, despite the current headwinds
It has been a testing start to the year for emerging markets. While there was wide recognition heading into the year that rising rates and inflation would present challenges, the Russia-Ukraine conflict has had far-reaching consequences that were perhaps underappreciated by many commentators.
How are emerging markets functioning after the initial sell off following Russia’s invasion of Ukraine?
AG: Markets recovered in March, but we have entered another sell off - in some cases surpassing levels we saw after the invasion. This is driven partly by the fallout from the conflict, mainly through greater inflation concerns and more aggressive monetary policy in response, but also growing concern around global growth. Most of the key risks we are facing are global, not EM-specific. If you look at US credit, year-to-date returns are not dissimilar to what we are seeing in EM corporates or EM local currency debt.
NZ: While the non-energy trade links with Russia were not very significant across EM, the indirect spill overs are having a material impact, mostly through the price channel. Even before the war, inflation was running uncomfortably high for many EM countries – since the war started, the pressures on food and energy prices have intensified, necessitating more proactive stances by monetary authorities to fight inflation.
This has compounded concerns around a global growth slowdown, particularly given the weak activity in China. While it is difficult to say there are clear winners in this environment, one dominant theme emerging is around the distinction between commodity importers versus exporters. Exporters are benefitting from terms of trade gains, despite offsets, while importers are seeing fiscal costs rise from having to mitigate against soaring food and energy prices. That theme is shaping the way we think about the spill overs to the asset class.
Figure 1: EM – deviations of headline and core inflation from target (per cent)
Source: Aviva Investors and Macrobond, April 2022
Are emerging market sovereigns and corporates still able to access primary markets?
AG: Primary markets are still open, but in the past couple of months it is more about accessing windows of opportunity. The corporate funding market is probably easier than it is for some hard currency sovereigns. Issuing new bonds in this environment is less an issue of access, and more about cost. In the high-yield segment of EM, we have seen yields move to levels that will make many borrowers unwilling to issue because the cost is unsustainable.
How are sovereign and corporate balance sheets holding up against surging inflation and debt-servicing costs?
NZ: With sovereigns, we’re seeing differentiation between countries with more fiscal room that can spend to help alleviate social tensions, covering higher food and energy prices. In many cases, they have commodity export revenue coming through, which, combined with higher nominal GDP growth, have exceeded projections. They can offset extra costs with minimal deterioration in their fiscal positions. This is largely the case in Latin America and commodity producers more generally.
We’re seeing differentiation between countries with more fiscal room that can spend to help alleviate social tensions
Then you have a second tier that are having to pay up for food and energy, as well as rising defence costs, without having the commodity revenues to fall back on; I’m thinking about CEE countries like Poland, Hungary and the Czech Republic. However, they have more ability to absorb some of these pressures because the starting point for their credit fundamentals are better.
Then we come to the third tier, large commodity importers with less fiscal space and higher costs to bear; countries like India, Turkey, or Egypt. Their revenues have held up so far but, as things progress over the coming months, the effects of higher costs will really start to bite. Particularly at risk are countries in the frontier markets that already have limited fiscal room in large part due to large debt-servicing costs. We will be keeping a close eye on the second and third tiers, particularly in terms of how it will impact their issuance needs and servicing costs.
Figure 2: EM fiscal balances (2022 versus 2021, per cent of GDP)
Source: Aviva Investors, Macrobond, IMF Fiscal Monitor, April 2022
AG: The starting point for corporates was relatively strong compared to sovereigns. It’s also worth noting commodity exporters form a reasonable part of the corporate market. We have seen an improvement there with decent results from the majority of companies. At the same time, some will be impacted by slowing growth and the issues Nafez highlighted. While they are relatively well placed to deal with those, investors will be looking at that resilience to protect them as opposed to seeing it as a positive catalyst.
What impact is the rising rate environment in developed markets having?
AG: The impact is real. It’s forcing borrowing costs higher for all issuers. Every asset class in fixed income is seeing higher yields than they were at the beginning of the year. Borrowing costs are approaching unsustainable levels for a growing number of countries, less so companies. From a corporate perspective, we're at a stage where it could start to impact capex plans and the implementation of strategies. But with sovereigns, some countries can only access financing at levels where it doesn't make economic sense.
NZ: Environments where US rates are rising are rarely good for EM sovereigns given that they tend to accelerate capital outflows, especially if the backdrop is one of a strong dollar. And debt levels in EM have been rising, not just during the era of globally low interest rates following the 2008-09 crisis, but also more recently in response to the COVID-19 shock.
We are entering a phase where the IMF is going to play a bigger role
Now, as US rates begin to rise, there are already a number of sovereigns, specifically frontier names, either in, or about to enter, distressed territory. I think we are entering a phase where the IMF is going to play a bigger role.
More broadly, the proportion of revenues that go to servicing debt is at a multi-decade high. That doesn't necessarily mean we’re going into a crisis, but it does mean the backdrop is more vulnerable. That said, most EM nations are in better shape to weather higher rates than they were in the run-up to the last similar episode, the 2013 Taper Tantrum. Specifically, current account balances are much healthier, as are the level of foreign exchange reserves that can act as buffers as US liquidity conditions tighten.
Figure 3: EM current account balances versus reserves (end-2021 versus pre-taper tantrum) (per cent)
Source: Aviva Investors and Macrobond, April 2022
You referenced the importance of China to other EM countries. What’s the outlook there?
NZ: The China context is initially one of a policy-induced slowdown, with a wave of Omicron colliding with their zero-COVID policy towards the end of last year and early this year. That led to a significant deterioration in the growth outlook and, so far, the policy response has been weak. Normally, at this point of the cycle, you would expect the Chinese authorities to intervene through more forceful spending and aggressive rate cuts, but they've instead taken a measured approach. One of the reasons for that is they have new guidelines around common prosperity and reigning in excess leverage in certain sectors, particularly property. And, because of the weak global backdrop and the US hiking rates, cutting Chinese rates might not be the most effective way to counter the challenges.
Cutting Chinese rates might not be the most effective way to counter the challenges
We're coming to a turning point. Policy will have to be much more accommodative to achieve a growth target for China of around 5.5 per cent, especially given that consumption is unlikely to drive growth this year due to widespread lockdowns. It remains to be seen, in the absence of significant easing of property sector curbs, whether the announced ramp up in infrastructure spending can be executed in large enough magnitudes to support growth this year.
The implications on EM of Chinese growth dipping below five per cent and closer to, say, four per cent would be wide ranging as this would pose a drag on global growth, adversely affecting commodity prices, trade balances, and other kinds of external support.
The higher probability is that the authorities will step in and do what's needed -maybe a bit late – but enough to manage a soft landing that won't necessarily upset the global economy. This would at the very least help to keep EM current accounts supported as their financial accounts come under pressure from higher rates and tighter US liquidity.
What were the key takeaways from the recent IMF/ World Bank meetings?
AG: The general tone was negative, which has fed into worsening sentiment. Historically, these meetings tend to focus on risks and can often sound more downbeat than the situation is. This time, although there was nothing surprising, some of the themes highlighted are genuinely concerning, which has focused attention on areas like food security, rising poverty as well as macroeconomic concerns. If they were to materialise - and it's still an if - what we're seeing in the markets right now reflects greater concerns around those risks and awareness of the potential impact.
Russia-Ukraine is now viewed as something likely to last much longer with the aftereffects felt more widely
The hope that Russia-Ukraine would be an isolated event, with the potential for a quick resolution, is now viewed as something likely to last much longer with the aftereffects felt more widely.
NZ: In addition to the very dominant theme around food security, one of the longer-term risks discussed was geopolitical decoupling, with a shift away from the Washington-consensus style of globalisation into something more multipolar or bipolar. A theme that could come out of that is reshoring of supply chains in ‘friendly’ countries, which could put regions like Latin America at an advantage given the proximity to the US versus, say, Asia. That is a theme investors need to assess in detail.
Clearly this is not an environment to be making huge positioning moves, but looking across the EM universe, where are you seeing opportunities?
AG: While it is difficult to put current macro themes in a positive light, we can be more constructive around the fact risks are increasingly reflected in asset prices. You are being paid a reasonable amount for taking on risk, and that does offer a degree of protection and opportunity. The risk-reward for a longer-term investor is looking more appealing.
Whenever there are signs of stress, that's generally when you're presented with opportunities. It’s about understanding those risks and how they will impact countries and companies. When I look back over the past ten years, our best and biggest opportunities have come from picking the winners or names relatively better off during periods of challenge. You have to get your market direction call right and come close to an optimal entry point to enhance returns through credit selection. But it’s not just about pricing; it’s also about being comfortable volatility levels are stabilising.
NZ: On the local currency side, opportunities are likely to present themselves in countries where central banks have pursued an orthodox and proactive stance to stem inflation. Once the prospects for peaking inflation become clearer, the local-currency debt of countries that have built up large rate differentials with developed markets will be attractive, particularly in Latin America and CEE, whilst keeping in mind the political and geopolitical risks in both regions.
Should Chinese policy support be enough to achieve a soft landing, Asian countries with strong fundamentals like Indonesia and Malaysia should also benefit. The degree to which fiscal space is used prudently will also be a key differentiating factor among EM in the local-currency market.
From a hard-currency side, we can bucket opportunities into two areas
AG: From a hard-currency side, we can bucket opportunities into two areas. The first is selective high yield, where we're looking for countries with less vulnerability or more resilient characteristics. A country like Angola, which is heavily reliant on oil exports, is seeing quite significant benefits from rising oil prices, but that doesn't take into account the improved policy and governance over the last few years (with the assistance of the IMF) to maximise the benefit.
Nigeria is an interesting story. It is an oil exporter but doesn't necessarily benefit from higher prices because of the cost of subsidies. However, set against that, Nigeria’s long dollar bonds are trading at a yield of nearly 11 per cent. Fundamentals are seeing a slow deterioration from a relatively strong starting point and we believe current yields provide a significant cushion and the scope for attractive returns that can absorb some volatility.
The second camp of opportunities is in discounted long-duration bonds. Those tend to exist within the investment-grade market, where prices have fallen because of spread widening and rising Treasury yields. Your risk of capital loss is low because these are good quality credits. And with bond prices so low, that creates create a floor with the potential to earn decent carry.
In light of Russia-Ukraine, how are ESG considerations influencing your thinking at the moment?
NZ: It hasn’t changed the way we assess opportunities and risks. What it has highlighted, and this was also evident with the response to COVID-19, is that well-governed sovereigns and well-run companies are better able to deal with challenges and that in turn influences outcomes for investors.
The quicker you get your house in order, the easier it will be to sell your story to investors
It is as applicable to how they react to higher energy costs as it is to how they face up to the climate crisis and biodiversity loss. The quicker you get your house in order, and identify different pools of capital that are available, the easier it will be to sell your story to investors. That becomes even more critical in an environment where there is greater competition for capital.