Re-Emerging Markets

After two years of record-breaking outflows, is emerging markets debt due for a turnaround?

Today’s CIO Weekly Perspectives comes from guest contributors Rob Drijkoningen and Gorky Urquieta.

According to data from J.P. Morgan, 2022 was the worst-ever year for outflows from emerging markets debt, and 2022 – 2023 saw the worst back-to-back annual outflows. Almost $90 billion went out the door in 2022, with another $33 billion the following year. Some $5 billion more left in the first two months of 2024 alone.

That is not entirely surprising, given the upward movement in developed market bond yields and the U.S. dollar. Nonetheless, we think it may have been excessive and could be set to reverse. Global interest rates appear to have peaked, and emerging market fundamentals are generally strong, characterized by resilient growth, with well-entrenched disinflation dynamics and contained default risks.

Growth and Inflation

The International Monetary Fund’s latest forecasts, which align with our own expectations, have advanced-economy growth “declining slightly” to 1.5% while emerging economies “experience stable growth” of 4.1%.

To some extent, this is a benefit of the resilience of the U.S., but emerging economies are also getting support from declining domestic inflation. Some emerging market central banks have already started to cut rates, with easing inflation and the apparent peak in global rates giving them further room to ease policy.

A continuation of that easing is likely to support growth and bring down local-currency bond yields. Any easing from developed economies’ central banks would likely bring down hard-currency yields, too.

Sovereign Defaults

Recent years saw a surge in emerging market defaults as the pandemic and Russia’s invasion of Ukraine compounded pre-existing debt vulnerabilities and policy mishaps in several countries. Some defaults remain unresolved because they are linked to ongoing geopolitical tensions, but many others are close to reaching agreement.

Moreover, some sovereigns considered to be distressed coming into 2024 have since achieved positive developments, whether on the fiscal-policy front in Argentina and Ecuador, or via additional financing, as with Egypt’s investment deal with the United Arab Emirates and the loan top-up it received from the IMF. Other high-yielding sovereigns have responded to the financial pressures of the past four years with substantial economic and governance reforms, which have helped them secure support from the IMF and other concessional and blended financing.

As a result, we believe there will be no further sovereign defaults this year. This improving outlook could create a tailwind for the wider asset class, as we have seen with the recent reopening of the frontier bond market.

Corporate Liquidity Buffers

Global economic resilience and declining rates should also ease the pressure on emerging markets corporate bond issuers, in our view. Liquidity buffers are near decade highs and balance sheets are generally strong following years of corporate deleveraging, which means we anticipate relatively light issuance requirements this year.

In all, we believe the corporate default rate is likely to decline from last year’s 7.8% to below 5% in 2024. Much of the stress is concentrated in China’s real estate sector, and if we exclude that from our analysis, we think this year’s default rate could fall below 3.5%—which would be below the long-term historical average.

Valuations

The downside of this generally positive outlook is relatively high valuations, especially after the broad rally in spread assets at the end of 2023. At 375 basis points, the spread of the JPMorgan EMBI Global Diversified Index (EMBI GD) is quite tight to those of the ICE BofA Global and U.S. High Yield indices, at 350 and 330 basis points, respectively, and only marginally above its long-term average of 355 basis points.

However, we believe this masks the contrasting performance of the two halves in the emerging markets debt universe. Over the four years through 2023, the credit spread of the investment grade half of the EMBI GD benchmark has tightened by around 45 basis points while U.S. investment grade spreads remain about the same. In contrast, the spread of the high-yield half of EMBI GD has widened by 200 basis points while that of the U.S. high yield market has tightened.

For that reason, while some investment grade names remain attractive, in our view, many of the best opportunities for further spread compression lie in the high-yield segments of emerging markets debt.

Risks

Where do we see the major risks?

We already mentioned that we see much of this year’s default risk originating in corporate China. We think weak domestic demand and constraints on policy support are likely continue to weigh on China’s economic growth, and particularly its real estate sector—although we regard this as a risk to China itself more than a source of significant contagion into other emerging debt markets.

Instead, we believe the key risk is a reacceleration of global inflation—and last week’s U.S. inflation data was a reminder that this is very much a live one. Beyond this year, a return to a more aggressively protectionist stance in the U.S. in the event of a change of government would also pose a challenge.

Given our central scenario of stabilizing growth and inflation, however, we think a reversal of the recent substantial outflows from emerging markets debt could be in the cards for 2024.