Emerging market debt: A reversal of fortune?

Last year was characterised by rising interest rates in developed economies, multi-decade highs in inflation, rising commodity prices and war between Russia and Ukraine. The combination of these factors hit emerging market (EM) credit hard, with the asset class posting negative returns of 15.0%[1] for 2022.

However, between October and the end of last year EM credit rallied c.9.3% . This has reduced potential returns for 2023 but, based on several assumptions rooted in incoming data and policy changes, we believe EM credit as an asset class could still potentially perform well this year.

What are the drivers and assumptions that underpin our view?

Are things looking up?

First, inflation is peaking in both developed and emerging economies, driven by sharp increases in benchmark rates, weaker growth, and the turn in commodity prices, including for food and fuel. With price pressures abating, we believe benchmark rate-hiking cycles are thus also near their end.

While some data prints could lead to volatility, the likely plateauing of both inflation and rates implies developed country yields have seen their peaks. That bodes well for EM credit – declines in US Treasuries contributed c.11.4% of the total negative return in EM credit in 2022; we do not anticipate a similar drag on 2023 returns.

Secondly, the recession many analysts forecast this year is unlikely to mirror the highly correlated contractions we saw during both COVID-19 and the global financial crisis. This recession is likely to be focused on developed markets (DMs) alone. Indeed, of the 150+ emerging markets for which International Monetary Fund (IMF) projections are available, only four are forecast to see contractions in 2023, including Russia, Sri Lanka, and Chile[2].

It’s not surprising, then, that the IMF’s most recent projections for EM growth in 2023 are at 3.7% to flat. And this estimate does not include the impact of China re-opening its economy faster than expected.

In the meantime, other large Asian economies – particularly India – are likely to see growth of over 6% this year. This leads us to believe 2023 will not only see emerging markets continue to grow, but we anticipate their growth differentials with advanced economies could rise to levels last seen in 2016. The latter should be supportive for EM spreads, in our view. Also, should the recession in developed countries be short and shallow, this would also likely be supportive for EMs.

Third, although EM FX reserves have declined from their peaks of around $11 trillion, at $10 trillion[3] they remain more than sufficient to cover their $4 trillion of projected external debt. Furthermore, EM current account balances are expected to remain in surplus, albeit at lower levels than in 2022.

It is also worth noting that international financial institutions like the IMF, World Bank, Asia Development Bank and the Asian Infrastructure Investment Bank are continuing to provide exceptional support to emerging markets. This leads us to conclude the risk of an EM-wide debt crisis remains muted.

Fourth, technical factors around EM credit remain supportive. Bond issuance is expected to remain negative for the year. Cashflows – coupons and amortisation returned to investors – remain healthy. EM valuations – particularly in high yield – look in our view attractive versus yields in comparable fixed income asset classes, particularly as EM growth has been forecast to outpace advanced economies.

Meanwhile, flows have recently turned the corner after outflows reached c. $87 billion[4] at one point last year, and could further benefit from the above dynamics. Together, our view is that these technical considerations could be supportive of positive performance in emerging market debt (EMD), with returns driven by carry and some spread compression.

Bumps in the road

However, this does not mean there are no potential challenges to this view. The outlook remains subject to an unusual degree of uncertainty and significant risks.

In recent commentary after monetary policy decisions, DM central banks have not tempered their hawkishness despite softening economic indicators. If DM monetary policy tightens more than currently expected and stays restrictive for longer, this could well lead to a deeper than currently expected recession in advanced economies. We can expect risks on the DM monetary policy front to grow should China’s re-opening stoke commodity prices.

In domestic politics, there are elections in several large emerging markets, including Argentina, Turkey, Nigeria, Pakistan, Paraguay, Guatemala and potentially Peru. Several of these are likely to result in new governments, in turn increasing the risk of policy changes. Meanwhile, inflationary pressures remain exceptionally high in several high yield emerging markets, where household and social buffers are low. This poses a significant challenge to social stability, raising risks of protests.

Finally, on the geopolitical front, beyond the potential for escalation in the Russia-Ukraine conflict, the acceleration of missile tests by North Korea is alarming. Meanwhile, sabre-rattling around the China-Taiwan issue continues, and US relations with both China and Saudi Arabia warrant close monitoring. On the flipside, should the Russia-Ukraine conflict reach some form of ceasefire in 2023, that will boost sentiments towards emerging markets.

Taking a step back, emerging market credit has seen numerous shocks over the last few years, including trade wars, the China real estate crisis, the pandemic, the Russia-Ukraine conflict and the unprecedented increase in DM rates and inflation.

We believe the fact there has not been a systemic sovereign default crisis is reflective of how far emerging markets have come since the crises of the 1980 and 90s. This resilience is testimony to their improving institutions, better macro management and larger and more diverse economies. Especially given the events of the past few years, EM policymakers are now much more experienced in dealing with crises. That makes us confident in their trajectory in 2023 and beyond.

[1] Source: JPM Hard Currency Sov/Corp Blended Index

[2] Source: IMF

[3] Source: IMF, Bloomberg

[4] Source: JPM Flows data