1. EM public finances less affected by pandemic than DMs
The COVID-19 pandemic has impacted emerging market (EM) balance sheets, but to a lesser extent than in developed markets (DMs). The IMF sees EM government debt rising by 9.2% of GDP in 2020 to 61.4% of GDP by year end. Advanced economies are expected to see an increase of 20% of GDP to 124% of GDP, more than double that in EMs in both relative and absolute terms. This reflects a smaller hit on public finances, with EMs expected to see a primary deficit of 8.5% of GDP in 2020, a 5.5% of GDP increase from 2019. In contrast, the primary deficit in advanced economies is projected at 13% of GDP this year, an 11% of GDP increase over last year.
2. Global growth and trade rebound
According to the IMF's forecasts, 2021 will see the global economy rebound to 5.2% growth from -4.4% in 2020. EM growth is projected at 6%, its highest level in a decade, and 2% higher than that of advanced economies. This will support global trade volumes, expected to rise by 8% or more in 2021. Export volumes in EMs are projected to rise by 9.5%, their fastest pace since 2010. Furthermore, as 2021 wears on, we expect growth revisions in favour of EMs given the relative outperformance in Asia and China in particular.
3. Vaccine development
Progress in the development of vaccines should support risk sentiment given their potential to support a faster-than-expected global growth rebound.
4. Lower trade and geopolitical tensions
The incoming Biden administration is expected to follow a more inclusive, multilateral approach on the global stage. This should see a rebuilding of US alliances, lower trade tensions and a decline in Twitter diplomacy, which should help reduce volatility in financial markets.
5. Strong donor engagement
The IMF, other multilaterals and bilateral donors remain closely engaged with EMs. The IMF has provided financial support to more than 83 countries since the pandemic’s start, while bilateral creditors have provided 12 months’ debt service relief to more than 45 countries via the G20’s Debt Service Suspension Initiative that will last until mid-2021.
6. Supportive global liquidity conditions
The pandemic has seen G4 central bank balance sheets rise by 17.5% of GDP between March and September 2020 – a period of just seven months – a significantly faster and stronger pace than in the global financial crisis. Meanwhile, since the start of the pandemic, fiscal authorities around the world have launched unprecedented spending packages totalling nearly $12 trillion. Global liquidity hence remains abundant and cheap with benchmark rates at historic lows. In addition, the stock of negative yielding debt stands at $17 trillion (double March 2020’s levels). With these dynamics expected to remain in place for the foreseeable future, the search for yield should continue to support inflows to EMs in 2021.
7. Supportive valuations and technicals
We believe EM valuations remain attractive, particularly the EM high-yield component, relative to both US investment-grade and US high-yield bonds. On the other hand, while lower headline fiscal deficits should mean lower EM issuance next year, EM cashflows will likely be higher, with larger amortisation and interest payments returned to investors in 2021.
8. Supportive commodity price outlook
With a rebound in global growth prospects, commodity prices should remain supportive for EMs.
9. Range-bound dollar
Given its anti-cyclical characteristics (whereby the dollar is used as a funding currency to buy EM assets), the dollar is biased towards gradually weakening when global growth conditions are strong. Furthermore, with both the US and the ECB likely to continue their QE programmes until a recovery is firmly in place, this should weigh down the dollar and euro’s outlook, and prove supportive for EM currencies. We do note that if inflation expectations rise fast on the back of US growth outperformance versus Europe, that could cause US yields to rise, supporting the dollar. However, even here, with talk of average inflation targeting, we do not expect any significant spikes in real yields. Hence, we do not expect a sustained rally in the dollar next year.
The above, however, does not mean there are no risks. The near term could see actions by the outgoing US administration on China, Iran, trade and other issues that could raise volatility. Beyond the transition to the Biden administration, a divided US Congress could mean a smaller stimulus and potential delays in arresting the spread of COVID-19. Both could weaken the US recovery.
Downside risks to global growth also emanate from Europe on the back of lockdowns and the spread of infections. Within EMs, although Asian countries (outperformers on growth) have been more effective in controlling virus spikes, other large economies could be vulnerable to an increase in infection rates, all the more so as vaccine deliveries could take time. Conversely, if the vaccine leads to a faster global recovery than currently expected, inflation expectations could rise, pulling benchmark yields higher and the dollar stronger.
Finally, EM sovereign and corporate spreads have tightened by around 250 basis points since March in a rally that at seven months is now relatively mature. Although this implies next year will likely see bouts of consolidation, we believe the strength of the factors noted above could support a further 50-70 basis point rally, pushing EM spreads to pre-crisis levels of approximately 300 basis points. Sustained risk appetite could well then lead to the 240-260 basis point resistance range being tested.