2022 EM credit outlook: after a difficult year

Total returns on the emerging market (EM) sovereign index (JP Morgan EMBI GD) have been -3.15% for the calendar year to 30 November 2021. The EM corporate index (JP Morgan CEMBI BD) delivered just 50 basis points of returns through the same period. In EM sovereigns, this is the worst performance since 2018, and one of only six years in the past 27 when returns have been negative.

Several factors underpin this performance. As inflation and growth rebounded from COVID lows, US rates moved higher: on average, US benchmarks are 50 basis points wider over 2021 to date, and 80 basis points wider since August last year. Along with other factors, this helped the US dollar to strengthen, particularly from the middle of 2021, hitting EM local currency fixed income markets hard. Meanwhile, almost the entire move in EM credit spreads over 2021 has come since mid-November, driven by fears around the Omicron variant amidst very thin market liquidity.

Three areas of opportunity in 2022

1) Spreads in a negative-yielding world. EM spreads have widened back to levels comparable to where they were before vaccines became available, while the yield on the EMBI GD is nearly 5.5%, with the high-yield bucket above 8.0%. These valuations come at a time when issuance next year is expected to be lower, while cashflow (coupons and amortisation returned to investors) should remain supportive.

But it’s not just about valuations. The global stock of negative-yielding debt is still above $13 trillion, while the IMF’s EM growth projections of 5.1% in 2022 suggest EMs will continue to outperform pre-pandemic levels, which was on average 4.3% over 2017-19. In addition, fiscal deficits should continue to moderate and the addition to EM debt levels – half the level in developed markets – is likely to be modest.

2) Commodity prices are still supportive. While Brent crude prices are around $16 per barrel lower than previous peaks, the current $70 per barrel price is still higher than the fiscal breakeven oil price (the oil price necessary to balance the budget) of most oil exporters in the Middle East and North Africa region. If commodity prices hold, many countries – particularly in the EM high-yield sector – are likely to see their balance sheets and ratings improve. This has already been happening in recent weeks and months in Angola, Gabon, Kazakhstan, Oman and Nigeria. These positive rating moves could be a meaningful driver of spread compression.

3) Technicals remain critical for both high yield and investment grade, in our view. Price volatility during bouts of risk-off sentiment suggests caution is warranted in large issues and frequent issuers, and we believe it’s also important to stay cognisant of issuers which enjoy participation from local investors. Gulf Cooperation Council (GCC) countries, for example, have a relatively stronger bid price but Africa is catching up, particularly the likes of Nigeria, Kenya and Ghana.

And key risks to be aware of

We continue to monitor risks and challenges closely. Notably, as developments since mid-November have shown, COVID waves and variants continue to surprise markets, reflecting concerns around the impact on EM growth, US rates, and flows into and out of EM debt as an asset class.

That said, vaccination programmes across emerging markets are continuing while vaccine supply is improving. Just in the past few days, India has announced the resumption of exports to the Covax initiative, a key source of vaccines for 92 low income and emerging markets. Similarly, China has pledged another one billion vaccines to Africa, 400 million of which will be jointly produced. In the meantime, emerging markets have become more experienced in dealing with new COVID waves.

Another important risk is higher US rates causing sustained dollar strength, with a knock-on effect on dollar-denominated commodity prices, to which emerging markets remain tightly linked. This means lower commodity prices filter through to external accounts, public finances and debt levels. Hence, given risks that dollar strength could continue in the near term, our preference in the first half of 2022 remains biased towards EM hard currency debt rather than local currency, from a return/volatility perspective. We will also watch for potential action by commodity producers, should any fall in commodity prices persist. In oil, for example, there could be potential for OPEC+ to take measures to reduce supply.

Bull or bear in a China shop?

And finally, no blog on emerging markets is complete without a mention of China, where we have been closely following regulatory changes. While some of these measures have led to sharp falls in China’s real-estate bonds for example, it is important to remember that the Chinese authorities have stated that reaching the goals of common prosperity are more for the medium to long term. Meanwhile, the 20th plenary of the Chinese Communist Party is due in the second half of 2022; markets expect continuity in the country’s leadership, in the context of which we expect the government will be even more cognisant of ensuring reforms continue, while aiming not to create or exacerbate social challenges.

The bottom line is that while EM credit has weathered a difficult year, we believe the worst is behind us. In our view, emerging markets will continue to grow strongly, reduce fiscal deficits, and stabilise debt levels. Together with lower issuance in 2022, a large global stock of negative-yielding debt, healthy cashflows and attractive valuations, we believe 2022 holds positive opportunities for EM debt.