The 2022 picture for emerging markets is starkly different from the previous decade's 'taper tantrum'
EM (emerging markets) debt has been caught up in the general fixed income bear market – driven by rising inflation, monetary policy tightening, and risk aversion associated with the volatility of inflation and rates. What’s different from other bear markets is that rather than underperforming significantly, EM debt market returns have been broadly in-line with global bond markets, especially if you exclude Russia, which was marked down to zero. This speaks to the fundamental strength of EM economies today.
How does 2022 compare with the 2013 ‘taper tantrum?’
In 2013, a lot of investors had flooded into EM assets in search of yield, leaving valuations stretched. In addition, with hefty current account deficits some key EM economies were net borrowers of U.S. dol- lars and vulnerable to the U.S. rate-hiking cycle. The picture in 2022 is markedly different, not the least in terms of fundamentals: EM balance sheets have improved a lot, with current accounts flat or in surplus. This helped EM economies to weather the storm much better in 2022 and supports the view that what we’ve seen in bond markets is a global phenomenon, not an EM crisis.
Are EM sovereigns equipped to deal with the low-growth, high-inflation environment?
The steps taken by policymakers in EM – who have learned painful lessons from the past – have helped put many economies on strong footing. When inflation began to rise, EM central banks acted quickly to prevent it spiralling out of control. At the time of writing, 11 of the 18 largest EM local bond markets had seen rates rise by more than the hikes meted out by the U.S. Federal Reserve. Four had even paused hiking, having successfully reined in inflation. With EM inflation subsiding and much of the painful rate hiking done, nominal GDP is now rising and debt-to-GDP ratios falling. Coupled with strong fiscal positions, the overall picture for EM is robust. Reflecting this, at the IMF/World Bank annual meetings in October, most discussions around financial stability concerns centred on developed markets rather than EM. That said, the EM debt universe is diverse and there will be pockets of vulnerability given the challenging outlook, necessitating a selective approach to investing.
Which markets are most exposed to funding pressures?
While funding challenges are not an issue for the more core EM economies, some frontier markets are vulnerable, with Africa a key region caught up in the ‘sudden stop’ in foreign investor flows seen in 2022. However, the IMF appears intent on ensuring that liquidity risks do not spiral into solvency risks for countries that are engaged in the right reforms. Furthermore, we believe market pricing has already reflected these risks to a great degree.
To understand which countries are most vulnerable to tighter global liquidity conditions we use a proprietary credit vulnerability model. This looks at current economic, fiscal, external, and institutional factors of each country relative to peers and history and then combines this with a consideration of external liquidity vulnerability (reserves and gross external financing needs). We find a ‘tail’ of EM markets which appear to have over-borrowed in hard currency and could face challenges if yields remain elevated and the new issue market closed.
Turkey is also a key market to watch. While valuations in some cases overlook both the fiscal reforms EM governments are making and the support the IMF/other institutions are extending, investors will need to do their homework on a case-by-case basis.
Where do you find the most interesting opportunities?
Latin America has led the way in terms of orthodox policymaking this year, both within EM and on the global stage. Central banks in the region were the first to begin increasing interest rates and some of them are already through the hiking cycle; unlike many other bond markets, they are now trading to a different drum beat. We like Brazil in this regard, where the presidential election is also behind us, removing a lot of political uncertainty.
As for hard currency debt markets, with yields reaching levels not seen since the global financial crisis. we think there are plenty of attractively valued opportunities for investors to explore. We think Egypt has resilient fundamentals that the market is overlooking. It has secured significant support from the IMF, having done everything that was asked of it (including devaluing the currency). At 48 months long, we think the IMF program speaks of the fund’s confidence in the country’s debt sustainability, yet Egypt’s bonds are trading at very depressed prices.
What developments do you expect to see in 2023?
For investors with U.S. dollar denominated investments, 2022 was particularly tough. We expect the dollar’s relentless rise to come to an end at some point in 2023. An important catalyst for this will be the Fed coming to the end of its hiking cycle and U.S. interest rates peaking. We are already seeing signs of inflation falling, which is a positive signal.
As the monetary policy action of the past 12 months starts to really take effect on economies in 2023, we will see growth slowing and recession risk rising across some markets. That said, if China does – as an increasing number of market participants are predicting – relax its policy stance of having zero tolerance to COVID, that could spur an economic recovery that reverberates globally.
More broadly, the starting point for 2023 is a lot more favourable from a valuation point of view after such a challenging year for the asset class.
Peter Eerdmans is Head of Fixed Income and Co-Head of Emerging Market Sovereign and FX at FCT.
