A sharp shock
The COVID-19 shock hit emerging market bonds across the board. Corporate and sovereign spreads widened almost continuously from late February to mid-March, representing one of the fastest and largest such moves ever recorded.
The market recovery from late March has been supported by improving inflows and better risk sentiment, helping emerging market credit spreads retrace 60% of the widening experienced in February and March. The yields on emerging market benchmark (investment grade) sovereign and corporate indices have retreated from their peaks and remain higher than their developed-market counterparts, where some government bond yields have returned to record lows.
What lies ahead?
Amid quantitative easing by central banks in developed countries, we anticipate strong flows into emerging markets, as experienced in the wake of the global financial crisis. Each crisis is different, but post-crisis growth rebounds over the past 30 years have been stronger in emerging markets. A faster recovery is also likely to be supported by a better starting point for emerging markets: not only are their borrowing requirements lower than developed markets, but going into the crisis they had lower debt levels too.
As markets recovered, investment-grade emerging market issuers quickly regained market access and in the last few weeks we have also seen single B issuers such as Egypt and Jordan return to markets in encouraging sizes. IMF support for emerging markets has helped sentiment, and multilaterals such as the World Bank and African Development Bank have also stepped in. Meanwhile, the G20’s debt service suspension initiative (DSSI) has provided the weakest countries with time-bound relief.
Risks and reasons to be hopeful
The resurgence of COVID-19 remains a risk as economies reopen. However, certain things make us hopeful. First, barring outliers, second waves of the virus may be ‘pocketed’ rather than broad-based, leading to the use of localised ‘smart lockdowns’, rather than nationwide measures, which should be less damaging for employment and earnings. Secondly, while the initial COVID-19 pandemic was unanticipated, risks of a second wave have been well-flagged. In our view, emerging markets should therefore be better prepared for a second wave than they were for the first.
In balancing the opportunities and challenges, while we are constructive on emerging markets, we remain cognisant of the market movements since the extremes of March, which may increase the prospects for short-term profit-taking. Come September and once COVID-19 begins to fade in earnest, the potential for gyrations spinning out from the US elections, the evolving US-China relationship and the outlook for commodity prices are likely, in our view, to return to the foreground.
This article is an abridged version of one which appears in our Q3 Global Fixed Income Outlook. To read the full article and for more on our global fixed income views, please click here.