The fundamental picture for emerging markets (EMs) has deteriorated due to the Covid-19 pandemic. The global market sell-off in March impacted emerging market debt (EMD) severely, driving credit spreads to once-in-a-decade wide levels. The asset class has since rallied furiously, despite issuance running at a very high pace, as EM countries sought to alleviate the impact of the virus. But if EMs are set to continue their comeback over the next year, where will the opportunities and risks lie?
Following the abrupt spread widening to above +700 bps in the early spring, EM sovereign credit spreads have now tightened back towards +400 bps, reflecting investors’ improved sentiment and pricing out most of the negative growth scenario. NN IP presently identifies three reasons behind the recovery: the V-shaped growth recovery in China; official support for EM countries from the G20, IMF and China; and supportive monetary measures by the world’s major central banks, most notably the Federal Reserve’s move to rapidly shift rates to zero, commence an aggressive asset buying programme and introduce an average inflation targeting framework. Cumulatively, these helped to stabilize global credit markets.
“The medium-term outlook for EMD remains constructive, given the expected rebound in global growth next year and the likelihood that several EM countries will follow China’s recovery path. Ample global liquidity, the search for yield and the structurally dovish Fed will provide further support. With this support and the expected return of full-year EM growth in 2021, we remain constructive for the EMD asset class. Nor can we ignore the potential positive catalyst of a vaccine breakthrough.
Tactically, events such as the recent spike in the volatility of risky assets and a possible rise in geopolitical tensions between the US and China ahead of the US elections could offer attractive entry points for investors with a constructive medium-term outlook for EMD.”Marcin Adamczyk, Head of Emerging Markets Debt at NN Investment Partners
NN IP identifies the following opportunities and risks in EMD:
Sovereign and corporate hard currency (HC) bonds: A weaker US dollar is supportive for emerging economies and companies via trade and financial channels. USD-denominated EM bonds are often the first assets to benefit from this. The low real rates in the US are pushing capital to higher-yielding USD investments. A weaker USD also usually coincides with rising commodity prices which, combined with better refinancing conditions for EM issuers, support HC spreads and stimulate inflows into the asset class. In the HC sovereign space, higher-yielding bonds are seen as more attractive, particularly as spreads in the investment grade space have almost entirely recovered.
Asian corporate debt: These assets are particularly compelling because of very attractive valuations versus other regions and other credit asset classes, in addition to the support provided by the China-led growth rebound.
Ecuador, Egypt, Romania, UAE: While a degree of dispersion in country returns is expected, there are several interesting stories worth highlighting. Ecuador benefits from successful debt restructuring and substantial IMF support, amounting to USD 6.5 billion. Egypt enjoys strong bilateral and multilateral support from the US, Middle East, China, and the IMF, while Romania offers attractive valuations, despite political uncertainty in the country. Meanwhile, the United Arab Emirates is well-equipped to handle Covid-19 because of its robust healthcare system, and the normalization of relations with Israel is reducing tail risks for the country.
Local currency (LC) debt: The LC space is at present seen as less favourable, especially in some high-beta names such as Turkey, South Africa and Brazil, whose currencies remain weak, even versus the USD. In the longer term, however, LC-denominated EM assets could directly benefit from USD weakening not only versus other developed market (DM) currencies but also versus EM currencies. The key prerequisites for this, some of which have yet to materialise, include growth improvement in EMs versus DMs, positive and substantial carry differentials versus the USD, and lower foreign exchange volatility. The volatility angle is especially important given that rate-cutting cycles have reduced carry in many local emerging markets. Absent strong pull factors for EMFX, this makes LC debt more of a tactical play currently.