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Kirstie Spence
Harry Phinney
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Global backdrop driving emerging markets
The global macroeconomic backdrop has been the main driver of emerging market (EM) debt returns in 2022 and this looks set to continue in 2023. There are three main driving forces within this: tighter financial conditions led by the US, a stronger US dollar and weak global growth.
1. US financial conditions
US financial conditions (the ease with which finance can be accessed by firms and households) have tightened significantly in 2022, with the fastest and most extensive US interest rate hikes since the early 1980s. The rhetoric from the US Federal Reserve (Fed) suggests rate hikes are likely to continue, which could lead to further tightening.
Tighter US financial conditions directly impact EM debt through increased interest rates on US dollar-denominated debt. However, the difference in real interest rates (the rate of interest received by investors after allowing for inflation) offered by emerging markets compared to developed markets (DM) remains positive and attractive relative to other asset classes. This should help lessen the impact from tighter US financial conditions.
EM real yields have offered a 2-4% pick up over US
EM real yield minus US real yields
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Past results are not a guarantee of future results.
As at 30 October 2022. EM (emerging markets) represented by JPMorgan GBI-EM Global Diversified. EM real yields minus US real yields (10-year yields). Source: Bloomberg
2 The US dollar
Another important driver of EM debt in 2022 has been the continued strength of the US dollar, which has compounded losses in EM local currency debt and raised external financing costs for EM countries.
Despite seemingly stretched valuations, we’re unlikely to see a reversal of this trend until we see an end to US monetary tightening, some positive news from the Russia/Ukraine conflict – which would lessen the energy crisis and improve the European macroeconomic outlook – or some stimulus out of China. As soon as these factors start to change, we could expect the FX market reaction to be very sharp and the dollar could weaken very quickly, especially given current high valuations.
3. Global growth
There has been a sharp slowdown in global growth on the back of a faster pace of interest rate hikes, inflationary pressure and the Russia/Ukraine conflict, which in turn has put pressure on supply chains and commodity prices. As we enter a later stage of the Fed hiking cycle in 2023, market attention is likely to shift even more towards growth and specifically risks around a US recession.
The end of the zero-COVID policy in China could provide a timely boost to global and regional growth, but it looks unlikely to be the engine that boosts EM and commodity prices given the increasing limitations of its growth model and geopolitical pressures for de-globalisation.
De-escalation of the Russia/Ukraine conflict would likely be the main catalyst to change the direction of the current gloomy outlook. As we move toward the year’s end, that does not look likely.
Investing in EMD in the current environment
We are finding opportunities both within EM local currency debt and some higher yielding sovereigns, along with EM corporate bonds.
Local currency debt – preference for Latin America
EM local currency debt has held up relatively well so far in 2022, down less than 12% in local currency terms and just under 20% in US dollar terms1, reflecting the strong US dollar. Outside of the dollar, EM exchange rates actually outperformed most other developed market currencies so far in 2022. This is partly due to the proactiveness of EM central banks hiking interest rates early to control inflation.
While we could see further weakness if the global backdrop remains unfavourable in 2023, EM yields are already relatively high, while EM exchange rates are now at relatively cheap levels. High starting yields can help offset subsequent price volatility. As the chart below shows, two-year returns have been historically positive when yields reach 6.7% or higher.
We currently see the most value in Latin American countries, such as Brazil, Mexico and Colombia, that have hiked interest rates early. This has helped keep inflation under control and support exchange rates. Countries in Latin America have also been large beneficiaries of rising commodity prices and have been less exposed to the conflict in Ukraine.
EM yields may indicate an attractive entry point
Medium term (2-year) forward return when EM yields have peaked above 6.7%
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Past results are not a guarantee of future results.
Data as at 30 October 2022 in USD terms. Yield-to-worst (y-t-w) and forward returns callouts shown are for 50% JPMorgan EMBI Global Diversified Index / 50% JPMorgan GBI-EM Global Diversified Index. Callout dates for >6.7% yield shown: May 2010, September 2015, December 2015, October 2018, November 2018, December 2018. Forward returns based on annualised returns. Sources: Bloomberg, JPMorgan, Morningstar
Asia lagging EM rate hiking cycle
Policy rate changes
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As at 30 October 2022. Sources: Bloomberg, CEIC, Refinitiv
Opportunities in Central Europe look to be on the horizon. The low interest rate environment that we’ve seen in Europe for years is coming to an end. Central banks across the region have been aggressively hiking rates to tame inflation. Both the Czech Republic and Poland have kept interest rates on hold recently2 and may have now reached the end of their hiking cycles.
We remain cautious within Asia, as the region is still a few months behind Latin America in the tightening cycle. China’s low yields seem more justified than the rest of Asia in the context of a prolonged zero-COVID strategy, despite continued fiscal and monetary easing.
External debt – opportunities within higher yielding credits
Many of the more developed EM credits look fundamentally sound, despite the current environment. These countries are generally less reliant on foreign borrowing than in previous periods of volatility. They have lengthened the maturity of their debt issuance, and the foreign ownership of local currency bonds has broadly decreased, which should result in a lower risk of sudden reversal in capital flows.
Much of this positive outlook has been priced into the bonds, however, and we are finding more compelling opportunities within the higher yielding part of the asset class. We see value in some distressed or quasi distressed credits, where many of the difficulties have already been priced in, such as Tunisia and to a lesser extent, Ethiopia. We also like some of the higher yielding bonds deemed safer, whose spreads have widened alongside the broader sell off, such as the Dominican Republic, Honduras, Senegal and Angola and some high yield EM credits with access to external funding such as Egypt.
EM corporates – yield pick-up vs DM and diversification benefits
Fundamentals within EM corporates look to be in better shape compared to DM corporate peers as EM corporate treasurers have taken a more prudent approach to borrowing compared to DM corporates. Excluding problematic areas of the Chinese property market and Russian and Ukrainian issuers, the year-to-date (YTD) EM corporate default rate is just 1.2%3.
Outside of the pick-up in spreads relative to an equivalent non-EM bond of equal duration and rating, the geographic representation and risk structure of EM corporates is quite different to sovereigns, and so provides an element of diversification. Shorter-dated investment-grade bonds inside the corporate world can offer more defensive positioning. These bonds have proved quite resilient during times of volatility.
Conclusion
The global backdrop remains a key headwind for EM debt and volatility is likely to persist in 2023. That said, valuations have markedly improved and EM debt now seems to be pricing in known risks and, as such, could offer attractive return potential for research-based, long-term investors. We see opportunities in select higher yielding hard currency sovereign and corporate bonds, as well as in certain local currency countries that have been proactive in their monetary policy responses.
1. As at 21 November 2022. Source: JPMorgan GBI-EM Global Diversified Index
2. At 3 November 2022 meeting for the Czech Republic. As at 9 November for Poland. Sources: Czech National Bank, National Bank of Poland
3. As at 11 October 2022. Source: JPMorgan
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