After two weeks of panic and dislocation across emerging bond markets in March, followed by unprecedented capital outflows, investors are returning cautiously.
We are convinced that price levels in some areas of the market now offer investors opportunities, so they should not be paralysed by the low visibility of economic growth in many emerging countries. Other factors must be taken into account when making an investment decision.
Such an assessment makes us relatively confident about the outlook for emerging market fixed income, particularly debt in US dollars.
The latest IMF forecasts – released on 14 April – showed emerging economies contracting by 1.0% in 2020 (followed by a 6.6% rebound in 2021), with wide disparities among the major countries. This illustrates one of the differences between the crisis we are experiencing now and the Great Financial Crisis of 2009, when emerging economies continued to grow.
Should an investor in emerging bonds be worried about this and the somewhat disappointing economic data from China where the recovery in industrial production does not seem to be accompanied by a recovery in services activity? Not if they invest in the sovereign debt markets.
On the one hand, economic difficulties are likely to prompt authorities to strengthen their fiscal and monetary policies to support activity in both developed and emerging countries. Cuts in policy rates, in particular, are favourable for the emerging sovereign debt markets.
On the other hand, Chinese consumers’ reluctance to spend does not (on the contrary) call into question efforts on higher public spending and investment, particularly when it concern infrastructure.
Finally, given the chronology of the epidemic, China will be the first economy to fully emerge from recession. This should support activity across Asia and push up commodity prices, which in turn will benefit commodity producers. Even if recent data has disappointed investors hoping for a V-shaped recovery in China – and there are fewer and fewer of them – the U-shaped recovery that we expect should be positive for emerging market debt.
The improvement in the cyclical situation, suggested by the bottoming-out of activity surveys in April, and the return of investor appetite for risk assets in general are two other important factors favouring emerging market debt.
Some two months ago, sovereign and corporate risk premiums had risen extremely rapidly and to unprecedented levels. For almost two weeks, trading was practically impossible due to the widening in bid-ask spreads. Markets have since normalised somewhat, but liquidity remains limited and risk premiums are still high.
This setup offers investors opportunities that have not been seen for more than 10 years. In our view, EM debt valuations are attractive both relative to history and relative to other asset classes.
For example, while developed markets, including corporate debt, have been supported by central banks (the US Federal Reserve and the ECB, in particular), investors have been more reluctant to reposition themselves in emerging market corporate debt. Flows have been positive, but still limited, since the beginning of May, and issuance has picked up. These, too, are encouraging signs as countries and companies again have access to the market
Current premiums, as known as spreads, incorporate expected default risks that we believe are far too high given the underlying fundamentals. It should also be borne in mind that in the event of default, the recovery rate is generally higher on emerging market, private and public, debt than for other market segments, particularly in the case of the ‘small countries’ that are usually accompanied by the IMF in their decision to default.
Investor reluctance to return to emerging market debt after the panic in March could be explained by
The first element does not stand up to a thorough analysis, in our view. In this respect, our local presence is a strength, all the more so since security selection will be even more crucial in this crisis than in a normal situation.
As for the second aspect, it is important to understand that, barring exceptional circumstances, the solvency of states should not be fundamentally altered by the consequences of the COVID-19 epidemic.
The lack of visibility is particularly evident in Latin America, where countries such as Peru or Ecuador may indeed experience difficulties.
However, there is no need for general distrust. Consider Brazil. Its poor management of the epidemic, which has opened up a political crisis, is visible in the health data: the country became the world’s third largest for the number of confirmed cases on 18 May. Nevertheless, even if the recession is expected to be deep, Brazil’s solvency metrics have remained positive thanks in particular to the high stability of foreign direct investment.
We believe that investors should view the current levels for EM debt in hard currency as entry points. As for the local currency debt market, this suffered severe jolts during the crisis. The current situation requires investors to take relative country positions rather than a directional view.
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