Emerging market (EM) investors face a number of headwinds. Inflation is high and climbing. The Chinese economy is decelerating, as the country’s zero-Covid-19 policy takes its toll. Central banks, both in EMs and globally, are tightening policy. The geopolitical landscape remains a morass. And, at the time of writing, the emergence of the Omicron Covid-19 variant is a growing concern. So, the question is: have emerging markets already lost the battle for 2022?
Admittedly, it is tough to see a groundswell of foreign investors flooding into EM credit. However, what the asset class does have going for it is valuations. As the chart shows, the gap between EM and developed market (DM) real interest rates has reached historic levels. Real yields on 10-year EM bonds are pretty much in the middle of their historical range. By contrast, equivalent DM real yields are in record negative territory. As for inflation, 2021 delivered a once-in-a-century supply-side shock. It’s no surprise that neither investors nor central banks know just how transitory inflation pressures are going to be.
In our view, it is unlikely that inflation will dissipate aggressively enough to bring DM real yields into positive territory. So, despite the first inklings of monetary policy tightening among DM central banks, it’s probable we will still be operating in a lower-for-longer interest rate environment for the foreseeable future. The valuation gap between EM and DM bonds is therefore set to remain a feature. Despite the persistence of EM headwinds, this should encourage some less risk-averse, yield-hungry DM investors into EM bonds. Moreover, we expect EM inflation to ease in the next three-to-six months, which should drive real yields even higher.
The gap between EM and DM real bond yields has reached the highest ever
Clearly, the real yield differential between EM and DM has not been supportive of EM currencies. But as we know, currency markets are notoriously fickle. Indeed, we wouldn’t be surprised if interest rate differentials became the primary driver of currencies. After all, expectations of a faster rise in US policy rates vis-a-vis Europe have supported the dollar to the detriment of the euro.
Looking ahead, we think the US Federal Reserve could begin hiking rates as early as March and likely two more times during the remainder of the year should inflationary pressures persist. This contrasts to our previous conviction that rates wouldn’t rise until the second half 2022. At the same time, we expect EM central banks will continue to increase rates over the first half of the year. All things being equal, this policy tightening should push interest rate differentials even higher, at least at the front end of many yield curves.
In our opinion, we will probably reach peak inflation sometime in the first half of next year. We think this will be grounds for a rally in the front end of certain local-currency bond markets, as some of the hikes priced into local curves are priced out. If we were to hazard a guess, this might occur in some of the first-mover markets. For example, Brazil and Russia, where central banks started their rate-tightening cycles relatively early.
The final area where the valuation argument applies is credit. This year, we have seen a significant divergence between US high yield (HY) and EM HY/frontier bonds. The outperformance has been stark. US HY returned 4.5%, while EM HY and frontier bonds were (un)comfortably in negative territory.
Spreads between the two asset classes have widened to levels not seen since 2004 (see chart).The strong performance of US HY is understandable. Several fragile single-B/CCC credits, many of which are energy firms, took advantage of high oil prices to term-out their upcoming liabilities (i.e. they capitalised short-term debt to long-term debt). As a result, US HY default rates have collapsed to their lowest levels since 2007. Fair enough, we all know what happened in 2008, but a repeat occurrence doesn’t appear to be on the cards. That’s because many companies have pushed out liabilities to much longer seven-to-eight-year maturities. In doing so, they will avoid a debt-service crunch next year, which will keep default rates low.
But what of EM HY/frontier bonds? Don’t those markets usually benefit from higher oil prices? The answer is yes – but it appears that they didn’t get the memo this year. Another factor is very real fears of a slowdown in China. EM HY/frontier exporters are far more reliant on China than their US HY counterparts. Add in costly attempts to deal with Covid-19 and you can see why EM HY/frontier bonds underperformed, despite rising oil prices.
EM HY and Frontier spreads attractive compared to US HY
So, will all this change in 2022? Yes and no, depending on the credit. There are numerous factors to consider. Omicron is a worry. More generally, however, we have also seen an accelerated take-up of the vaccine in a number of EM countries. These include Argentina and Brazil (where vaccination rates exceed the US), Uruguay Chile, Korea, Malaysia and China. Nevertheless, while we’re encouraged by the progress, Covid-19 will likely remain a prominent factor in the coming months.
China’s economic slowdown and persistent global inflation will remain major themes. There is also the risk that expanding European lockdowns or winter Covid-19 outbreaks in the US will drive oil prices lower.
Additionally, there is a heightened default risk within the asset class. By our count, roughly one-fifth of the countries on the JP Morgan Next Generation Emerging Markets Index (NEXGEM) are either restructuring or under the threat of restructuring their debt in the next couple of years. This is in stark contrast to the benign US HY backdrop. In practice, we believe the default rate is going to be much lower, as the implied default rate is about half that. Nonetheless, nations to keep an eye on include El Salvador, Ghana, Sri Lanka and Tunisia.
This speaks to the highly undiversified nature of the NEXGEM and why we only use it as a reference point for our frontier-bond strategy. Nonetheless, the default risk is real and will likely serve to dissuade certain investors, at least in the riskiest segments of the asset class.
That said, given current spread levels, we believe investors are more than handsomely compensated for the risks in a number of frontier countries. This is especially true where the risk of default is overstated and where near-term debt servicing is minimal. For example, Angola, Cameroon, Ivory Coast, Senegal and Pakistan.
In our view, 2022 will undoubtedly be a challenging environment for investors in the face of Fed tightening and the ongoing deceleration of the Chinese economy. However, valuations in both emerging local currency and credit markets have already priced in these headwinds to a great extent compared with their DM counterparts. We believe this creates opportunities for diligent investors.