Emerging market debt: the case for (cautious) optimism

Global markets have had a tough year.

Equities are down, nominal and real yields on US Treasuries are higher, volatility is high, and the US dollar has strengthened.

As a result, year-to-date emerging markets (EM) sovereign returns are -17.0%, with the UST component accounting for -9.2% and credit spreads -8.6%.

EM credit has not experienced negative returns in the first five months of the year to this extent since 1994.

As a result, EM yields have increased significantly.

EM sovereigns are currently yielding 7.8%, corporates 6.6% and local market debt 7.0%.

Other than the short-lived COVID-19-inspired peaks in early 2020, these are the highest yields since the global financial crisis. At these levels, we are looking at nearly 65 basis points (bps) of carry a month.

These yields are backed by supportive technical factors.

Cashflows back to investors, in the form of interest and amortisation payments, are estimated to be 9% higher this year compared to 2021. Meanwhile, new issuance – where these cashflows can be deployed – is projected to fall 25% in gross terms and 50% in net terms. Realised issuance could even be lower than currently projected, given the numbers year-to-date.

At the same time, we believe valuations below historical norms and supportive technicals are backed by a decent macro picture.

Healthy EM debt ratios

International Monetary Fund (IMF) projections for the end of 2022 suggest government debt and deficits will be lower in most EMs compared to COVID-19 peaks. Indeed, fiscal deficits are seen falling in 65 out of 72 emerging markets with traded external debt. More than half should also see debt ratios decline, while another 20% are projected to see debt rise by just 3% of GDP. Overall, EM government debt ratios remain half the levels of developed market (DM) economies.

With strong commodity prices, EM trade balances are running at over $700 billion on an annualised basis: their highest level since the global financial crisis. We believe this should help improve external sector outcomes.

Indeed, IMF data suggests 25 emerging markets out of 72 for which data is available will see current account surpluses in 2022. A further 16 could see modest deficits of under 3% of GDP.

Separately, in the same set of 72 countries, 30 could see current account balances improve in 2022 versus 2020. A further 15 could see an increase of just 2% of GDP or less.

EM external liquidity has also been helped by the strong support provided by multilateral agencies.

Initiatives such as the G20’s Debt Service Suspension Initiative (DSSI), last summer’s special drawing rights (SDRs) allocations and post-COVID-19 IMF lending to 90 countries have together channelled $475 billion in support to EMs. It’s pertinent to note the IMF does not lend to countries where debt levels are unsustainable.

And it’s not over.

The G20 has proposed a re-channelling of another $100 billion in SDRs from richer to poorer countries, via both existing and new IMF lending facilities. One of these new avenues is the IMF’s $45 billion Resilience and Sustainability Trust, established late last month to channel long-term low interest financing to emerging and frontier markets.

The inflation issue

Where there is concern is in the growth and inflation outlooks.

EM growth in the first quarter of 2022 was around 5%, but second quarter data will likely be weaker, reflected in weakening PMIs and Asian export growth. The IMF projects 2022 EM growth of 3.8%, versus 3.3% in DMs, with the average EM-DM growth differential projected to rise to 2.6% over 2023-25 – higher than pre-COVID-19 levels.

On price pressures, while inflation aids in lowering debt ratios given its impact on nominal GDP growth, it is a double-edged sword.

This is particularly true in single B-rated countries where price pressures are running significantly higher than in investment grade credit. This is challenging, as GDP per capita levels are lower in lower-rated countries, while inequality is typically higher and food and fuel prices are a larger part of consumption baskets. Together, this can impact social stability.

In response to higher inflationary pressures, EMs are significantly ahead of DMs in the policy tightening cycle: the GDP-weighted policy rate in EMs is 4.4%, versus 0.45% in advanced economies.

However, we do note that if EM rates rise more slowly given growth considerations, this near 4% differential could narrow as DM rates rise at a faster pace. This could pressure EM local markets.

That, in our view, makes EM hard currency an interesting area to explore.

Moving forward

Looking ahead, if slowing growth, quantitative tightening and rising benchmark rates lead to inflation peaking in the US and in the process help to calm volatility in rates, this is potentially supportive to EM debt in the second half of 2022.

Meanwhile, at this point the bar for negative returns is relatively high – all else equal, it would take over another 100bp of widening in USTs from current levels to get negative returns on the EM sovereign index.

However, our modelling suggests that just 100bps of spread tightening – returning to levels seen in early April – could potentially deliver investors a return of c. 14.7% over 12 months.

We believe this kind of opportunity to generate returns, in an asset class supported by strong technicals, cleaner positioning and no systemic debt or deficit concerns, is unusual – but not without risks, given the overall trends in markets so far in 2022.