After a bruising 12 months, our emerging-market debt team anticipates an improvement in the asset class’ fortunes in 2023 as declining inflation allows central banks to ease back on monetary tightening. But with many issuers still at risk of default, investors will need to tread cautiously.
Read this article to understand:
- Why now offers a potentially attractive entry point for emerging-market debt
- Why opportunities can be found at both ends of the risk spectrum of EM sovereign debt, but selectivity is critical
- The relative resilience of EM corporates versus their developed-market peers
2022 was a tough year for investors across all asset classes, including emerging-market debt (EMD). Russia’s invasion of Ukraine set off a negative spiral, which saw higher commodity prices feed into already elevated inflation. This encouraged central banks, especially the US Federal Reserve (Fed), to tighten monetary policy aggressively, prompting a sharp rise in the dollar. These factors weighed heavily on emerging-market assets.
Sentiment was further undermined by a weak Chinese economy as the country’s zero-COVID policy led to widespread lockdowns and upended global supply chains. Fears several countries will struggle to repay debt in the face of weaker economic growth, after fiscal positions were hit by the fight to contain COVID-19, were uppermost in investors’ minds.
Hard-currency EMD saw a loss of around 15 per cent over the course of the year, with local-currency debt down 12 per cent. It was an equally tough year for EM corporate debt, with the asset class down 13 per cent.
At the beginning of 2023, however, there are grounds for optimism, not least recent signs inflation may have peaked in the US and elsewhere. While the Fed has signalled it is in no rush to halt monetary tightening, markets could start to sense rates are close to peaking should inflation continue to subside.
In any case, with yields having risen so sharply in 2022, EM bonds arguably now offer investors as attractive an entry point as has been available for some years. In terms of local-currency debt, the fact EM currencies are now cheaper in real terms than during the global financial crisis is adding to the sector’s attractiveness.
Defaults and restructurings will remain a key focus for sovereign debt investors in 2023. We expect Sri Lanka, Zambia and Ghana to complete their restructuring processes over the course of the year. The size of haircuts, as well as the speed at which restructurings are completed, will be important influences on investor appetite for high-yield EM credits going forward.
Pakistan is at high risk of defaulting in 2023, particularly if the country’s International Monetary Fund programme goes off track. Whether or not the same fate befalls other nations will depend on the pace at which they can grow their economies and the speed at which they can regain access to financial markets.
Strong credit metrics
While the challenges facing EM nations have mounted since the pandemic, and the pile of distressed debt has grown, most countries in the universe have proven their resilience and have relatively strong credit metrics compared with developed countries. The key in 2023 will be to limit exposure to countries with the biggest vulnerabilities and those with the greatest sensitivity to the external financing environment.
In terms of the hard-currency universe, with debt from around 70 sovereign and quasi-sovereign issuers to choose from, investors have plenty of scope to identify opportunities. The fact the universe contains both investment-grade and high-yield debt is unusual in a global credit context and offers an appealing proposition.
Investors will likely want exposure to bonds at both ends of the risk spectrum given the value that has been created in high yield
While concerns over riskier debt remain, investors will likely want exposure to bonds at both ends of the risk spectrum given the value that has been created in high yield. Moreover, expectations for net negative financing in 2023 by both sovereign and corporate issuers, combined with the potential for a reversal of the outflows seen in 2022, could provide a decent technical tailwind.
In the high-yield part of the EMD universe, we like countries where current economic policies are consistent with an improving or stable economic outlook. Diversified funding sources, when market access is challenged, will also be key.
Within this category, Ivory Coast, Angola, Senegal, the Dominican Republic and Paraguay are of interest. We also see select opportunities in distressed credits, particularly those with strong institutional frameworks where, in our view, recovery values are likely to be higher than current prices suggest. Ghana looks interesting in this context.
Figure 1: Breaking down the EMBIG (Z-spread)
Source: Bloomberg. Data as of December 23, 2022
As for local currency debt, the income available to investors should help stabilise returns, with local-currency bonds already providing historically attractive nominal and real yields.
Figure 2: Emerging markets, real rate spread to the US (10 year, per cent)
Source: Aviva Investors, Macrobond. Data as of December 23, 2022
Focus on real yields in EMD
We see three further potential drivers for a better year in 2023: inflation, central bank policy and currency movements. While investors will remain apprehensive about inflation, we believe it is almost certainly close to peaking, if it has not already done so.
Hence, while EM central banks may continue raising interest rates early in 2023, as the year progresses they will have scope to hold and ultimately cut them as inflation starts falling. As this happens, real interest rates should rise. That could be a trigger for EM currencies to start performing well as prospective real yields, adjusting for credit risk, are already much higher than those available in developed markets.
EM currencies are fundamentally attractive on a medium-term basis
EM currencies are fundamentally attractive on a medium-term basis with valuations cheaper in real terms than during the financial crisis and given the fact current accounts in many cases are in surplus.
The fact the growth cycle could start to favour EM countries, especially as China ends its zero-COVID policy, should add to an improved backdrop for EMD, even if the danger the US central bank tightens policy further than markets currently anticipate cannot be ignored.
As ever within EM debt, country selection will be crucial, as economic and political risks vary widely. Countries with strong credit metrics whose central banks have managed to remain ahead of the curve, such as Mexico, Brazil, Peru, and the Czech Republic, along with countries such as Indonesia with strong recovery potential, should outperform those such as Colombia and Poland that face fiscal and political risks.
Corporate balance sheets strong
As with sovereign debt markets, 2023 could also herald a turning point in fortunes of EM corporate debt.
Many EM companies have strengthened their balance sheets in the past couple of years, with leverage as low as it has been in a decade and well below that employed by the average US firm. For example, net leverage in the EM universe is 1.5X, versus 2.7X for US companies, according to data from Bank of America Merrill Lynch.
As for interest coverage ratios, a measure of a company’s ability to service its debts, it is at its highest level since 2012. Companies proactively refinanced in 2021 when interest rates were lower, meaning they have less need to tap international markets now and are better able to manage volatile financing conditions.
Considerable risks remain given ongoing uncertainty of US rates, global recessions, danger of policy mistakes in China, and the Ukraine conflict
However, we also recognise considerable risks remain given ongoing uncertainty as to the path of US rates, the extent of global recessionary forces, the danger of ongoing policy mistakes in China, even if not our base case, and the likelihood of a prolonged conflict in Ukraine.
So, while there are strong fundamental arguments for owning the asset class at current yields, there may be merit in retaining a bias towards more defensive market segments such as bonds issued by top-tier financial institutions, technology, utilities, media and telecoms and energy.
But when it comes to more cyclical sectors, investors may want to be extra selective and keep a close eye on earnings updates and any sign companies are struggling to access fresh lines of credit.
This document is for illustrative purposes only. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This material is not a recommendation to sell or purchase any investment.