Emerging market external debt continues to come under various pressures, not the least of which is the widening of spreads. This widening will continue as economic activity slows further, financial conditions tighten and commodity prices fall. What will happen to emerging market debt in the coming months?
EM external debt has been under renewed pressure with a -22% total return YTD and spreads widening by 225bp. While initially the sell-off was driven by duration and it is now the spread widening that explains the negative TR. We expect spreads to keep widening as economic activity slows down further, financial conditions are tightened, and commodity prices decline. We remain OW EM IG over HY as EM HY countries will take the brunt of it.
It comes on vulnerable balance sheets after the pandemic; thus, we expect more defaults for small EM HY economies in the coming years. EMs are still in a default cycle, and the number of distressed names has never been so high. That said, it is not a systemic risk, and international institutions have been providing support since the Covid and the IMF is turning more relaxed on debt sustainability. IG spreads will also widen but less significantly. EM IG countries are less vulnerable, and the average cash price is now attractive for EM investors, especially as EM IG can benefit from duration. On the other hand, EM HY will keep suffering from their high beta status and the liquidation of the large OW leading to further EM IG/HY decompression.