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Armed conflict, financial woes and inflation shocks have contributed to a tricky 2022 so far for emerging markets. But a broader, systemic crisis is not anticipated for emerging-market debt, and there might be reasons for optimism about a recovery.
Inflation, the invasion of Ukraine and debt woes have weighed on emerging markets in 2022
Factors behind debt crises in Russia and Sri Lanka are unlikely to be repeated elsewhere
Investors can take heart from the potential for recovery, with emerging-market debt historically performing well during rising US interest rates
Emerging markets have matured since past financial crises, but investors should remain selective
Emerging markets suffered a terrible start to 2022. Inflation shocks, the invasion of Ukraine, as well as crises in Russia (a result of the invasion of Ukraine) and Sri Lanka have raised fears of a domino effect of debt defaults. Nevertheless, now that the US Federal Reserve is raising interest rates, if history is our guide, there may be reason for optimism.
The JPMorgan Emerging Market Bond Index Global (EMBIG) was down just over 16% year-to-date through to 4 May. That poor performance has been led largely by an inflation spike that hit developing economies in 2021 and this year has spread to industrialised economies. Inflation coupled with the situation in Ukraine has sparked a commodity shock, driving the prices of everything from oil to wheat higher.
However, the decision by the US central bank to raise rates modestly in March and then on 4 May with a more aggressive 50 basis points hike – its largest change in two decades and the first back-to-back increases since 1994 – may mark a potential turning point for emerging-market (EM) debt investors.
Our analysis of the Fed’s previous two interest rate increase cycles (in 2004 and 2016) and the impact of those actions on EM debt reveals that the asset class tends to perform poorly in the months leading up to the first Fed hike. That dynamic played out as expected in the first months of 2022, with the JPMorgan Emerging Markets Bond Index Global Diversified down about 10% from the start of the year to mid-March. However, EM debt performed quite strongly in the three quarters following the first Fed move in both 2004 and 2016 (see Exhibit 1). That suggests that by the end of the year, EM debt may reverse losses from before the Fed’s first hike. So far, spreads against comparable US Treasuries have already moved lower from recent peaks, declining from about 525 basis points just before the Fed’s March move to about 450 basis points in May.
Exhibit 1: emerging-market debt has performed well after previous rate hikes
Source: Allianz Global Investors, Bloomberg, JPMorgan. Data as at 9 May 2022. Chart depicts the J.P. Morgan Emerging Markets Bond Index Global spread-to-worst. Investors cannot invest directly in an index. Past performance is no guarantee of future results. For illustrative purposes only.
Reasons to be anxious
Of course, there are reasons why some investors remain understandably anxious. Russia is expected to default in what would be the first-ever delinquency by an investment-grade EM sovereign issuer. However, given Russia’s ample foreign reserves and that fact that its crisis was caused by its government’s decision to invade Ukraine, it’s reasonable to expect that this unprecedented credit event is unlikely to be repeated by other investment-grade sovereign credits.
Similarly, Sri Lanka’s debt and political crisis is not a sign of broader systemic EM challenges but rather the result of poor policy choices, notably maintaining a soft currency peg – a foreign exchange regime that has been out of favour since Argentina’s 2001 default – coupled with very loose fiscal policy that was financed via central bank money creation.
Another reason to be constructive on EM debt is the fact that the asset class has significantly matured. Large current accounts coupled with the pegged exchange-rate systems that were common at the time were the primary causes of several crises in the 1990s. Now, EM economic metrics have improved. For example, in 2021, the aggregate current account among 69 of the 73 countries in the EMBI index (excluding four countries classified by the International Monetary Fund as special situations) was a surplus of 0.5% of economic output, a positive result not seen in the prior seven years, according to IMF data.
Current accounts have fallen in step with increased savings rates, implying a diminished need to borrow in US dollars. The number of issuers has grown from about a dozen issuers two decades ago to more than 80 countries now issuing US-dollar debt. At the same time, the majority of EM debt is now issued in local currencies, making these issues less vulnerable to volatile exchange fluctuations.
Selectivity can reveal opportunities
Still, selectivity is key, as evidenced by the hit index-tracking strategies took when Russia was removed from indices. Today, emerging markets are largely split evenly between commodity exporters and importers as well as between investment-grade and high-yield issuers. Investors may favour commodity exporters in Latin America and oil producers in Africa and the Middle East, while underweighting commodity-importers in Asia, particularly China, in our view. Countries such as Ecuador, Costa Rica and Mozambique, undertaking IMF structural reform programs, are also worth consideration, in our view.
Investors would also be wise to track environmental, social and governance (ESG) data, which could help spot potential opportunities and risks. For example, Turkey’s governance scores fell the most among EMs in the past five years, foreshadowing a subsequent asset price decline. Likewise, deteriorating ESG metrics over the past year in such places as Kazakhstan and Belarus showed that these countries’ debt issues would fare poorly.
While EM debt has underperformed in 2022, there is reason for optimism that the asset class could recover as the year progresses. The combination of economic fundamentals that have significantly improved over the past decade and favourable valuations (both in terms of absolute yields and spreads) set the stage for opportunities for investors willing to take a selective approach.
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Giulia Pellegrini is a Senior Portfolio Manager for Emerging Markets Debt at AllianzGI, where she focuses on EM sovereign debt strategies and Sustainable Investing. Prior to joining AllianzGI in 2020, she was Head of Sustainable EM Debt Investing at BlackRock since 2015. Ms. Pellegrini was previously Chief Economist for Sub-Saharan Africa in J.P. Morgan’s Emerging Market Research team in London and in Johannesburg and an Economist at the World Bank in the Africa Finance and Private Sector Development Department in Washington D.C. She started her career as an Economist at the Debt Management Office of the Federal Republic of Nigeria in Abuja. Ms. Pellegrini holds master degrees in Development Economics and in Econometrics from the University of Oxford, St Antony’s College and from Birkbeck College as well as a BSc in Economics from the School of Oriental and African Studies – University of London.
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