An underlying investment theme of concern is centred around a hidden, or not so hidden, crisis in emerging market debt. Is there a case for presenting such a narrative?
The International Monetary Fund (IMF) has made a nod in this direction, estimating that 30% of emerging market countries and 60% of low-income nations already are in, or nearing, debt distress. Total debt in emerging markets has hit a record high of more than $100trn (£78.4trn) – which amounts to a staggering 250% of GDP – up from $75trn (£58.8trn) in 2019.
China, Mexico, Brazil, India and Turkey are the largest upward contributors, according to the Institute of International Finance (IIF). There is no doubt that slowing global growth, high inflation and rising interest rates are squeezing emerging markets harder than more prosperous countries.
And several studies of economic crises indicate that low-income countries are often most vulnerable to economic stagnation and financial crisis when global debt levels reach record highs.
This is a problem, says Jayati Ghosh, professor of economics at the University of Massachusetts Amherst in the US. “The Covid pandemic destroyed emerging market economies much more significantly than they did in the rich world. These countries were not able to bring about the fiscal response that was required,” she says.
Not systemic
This presents a possibly depressing picture. It implies that investors should not only stay adrift from emerging market debt, but emerging markets in general. But this crisis can be viewed in other ways.
“There is no systemic emerging market debt crisis at present,” says Greg Smith, a fund manager within the emerging market debt team at M&G. Although he adds: “Debt pressures have increased across the board since the pandemic.”
Similarly, Amer Bisat, head of emerging markets fixed income at Blackrock, says a new approach to emerging markets is needed, but not necessarily for the reasons emanating from a debt crisis.
He suggests the emerging market debt debate should be viewed by looking at emerging markets over a longer timeframe, given these markets have radically changed during the past two decades. “A new mindset is needed when investing in emerging markets. The days where one invested in emerging markets as a ‘raw beta’ play are gone.”
Importantly, Bisat notes that changes in the emerging market landscape do not mean the asset class is not attractive. “EM 2.0, as we like to call it, still offers significant opportunities for potential durable returns. But investing in it requires a different investment approach.”
Navigating the markets
What is this magical new approach? “To successfully navigate the world of EM 2.0, investors must focus on differentiation, diversification, income, quality, disciplined risk management and rigorous research,” Bisat says.
But, as is often the case with emerging markets, he sounds a note of caution. “We believe it is tough to see an acceleration in capital accumulation in emerging markets, given continued de-globalisation pressures, rising levels of debt – that will make funding these investments harder to come by – and structurally higher global rates.
“Our judgement is that over the next decade we are more likely to see a gradual – though slight – worsening emerging market growth potential than to see a favourable reversal,” he adds. This, along with the debt scenario, suggests that emerging markets may be a less thriving environment.
And while Smith rejects the idea of an emerging market debt crisis, he concedes: “Despite the absence of a systemic crisis, several emerging markets are experiencing their own debt crises.”
There were six emerging market sovereign defaults in 2020, followed by Sri Lanka a year later and Ghana in 2022. “Which is a lot compared to infrequent sovereign defaults over the prior decade,” Smith says. Added to that is Ukraine, Russia and Belarus defaulting on their debt since Russia’s military aggression increased in February last year.
Emerging market dispersion
But given the changing nature of emerging markets, there are number of points to highlight. One is not all emerging markets are the same. “Our analysis shows that dispersion in emerging market asset price changes has already risen. We believe this trend will persist,” Bisat says.
His colleague, Tom Donilon, chair of the Blackrock Investment Institute, also expects a divergence in emerging markets, which has an impact from an investor perspective. “Some middle-income emerging markets, like Brazil and Mexico, may be able to ease policies and offset downward growth pressures. Others will engage with the IMF and absorb global shocks.” But, he adds: “Emerging markets with elevated debt levels could be challenged.”
Yet there is a further note of concern. “We worry about a lack of global co-operation on debt relief – particularly between the international financial institutions, including the International Monetary Fund, and China,” Donilon says.
This is an issue that exacerbates the problem. The main vehicles for global co-operation – the group of seven (G7) and G20, along with the IMF – have limited tools to deal with a global debt crisis.
Market lever
But for all that, asset allocation within emerging markets is too important a lever for investors not to use. “It is our view that dynamic asset allocation across emerging market asset classes is an important return lever for those seeking exposure to emerging markets,” Bisat adds.In short, investors should not get bogged down by talk of an emerging market debt crisis.
In this way, high quality emerging market assets should be a core part of a portfolio. “Emerging markets is a wide-ranging asset class with ample high-quality names that may offer yield pickups to their developed market comparators,” Bisat adds. And despite the wave of sovereign defaults, they have not caused contagion, caused other emerging markets to “default like dominos”, says Smith.
In fact, he says: “Most emerging markets, especially those with investment-grade credit ratings, are in a much stronger position than they were in previous decades. They tend to borrow at home, rather than in hard currency, and have substantial foreign exchange reserves to buffer shocks.”
This is extremely positive for emerging markets investors. Another reason for a more optimistic outlook on the asset class, despite the lurking debt crisis scenario, is that the majority of emerging markets have reached the end of their monetary policy tightening cycles.
A forecast substantial decline in headline inflation over the second half of the year should allow emerging market central banks to slowly commence their easing cycles. And fundamentals for the asset class have been fairly stable since the Covid-19 pandemic, particularly amongst lower-rated issuers.
Market debate
Another issue within the debate is often confusion about what constitutes the emerging markets asset class. This raises the question whether the term emerging markets is in fact redundant. To highlight this point, the official grouping from index providers, such as MSCI, contain a hotchpotch of countries from across the globe which often have little in common.
A striking change since the financial crisis of 2009 has been the rise, in index terms at least, of the two emerging market giants: China and India. China to 29% from 17% and India to 14% from 6%. The biggest losers have been Brazil (16% to 5%), South Africa (8% to 3%) and, of course, Russia (6% to zero).
This means that the famous acronym of ‘BRICS’ is pretty worthless as an assessment of emerging market potential given there are now only two left standing. Although it is safe to say that Brazil’s President Lula is trying to change that.
Whatever the travails in China, its economy has at least been relatively stable and growing steadily, Covid lockdowns aside. But the makeup of its stock market has been transformed.
In the case of India, its growth has been much more uniform. History also has some lessons to teach investors when it comes to emerging markets. The central point is that it is vital to stick to countries which are well governed and avoid those which are not.
Emerging market vices
Aubrey Capital Management has been following this trend with interest. Those that cannot control “their vices, usually inflation, rampant corruption, or both,” are doomed to remain “peripheral players, even if their populations and demographics suggest otherwise,” says Rob Brewis investment manager at Aubrey.
Turkey is a case in point. The country was, and potentially remains, huge: a decade ago it was 2% of the benchmark and growing. Yet today it is 0.6%, and that is only after last year’s Ukraine driven bounce – given it was a rare winner from the conflict.
Turkey has also voted “to continue its decline,” according to Brewis, with the re-election of Recep Tayyip Erdogan as president. Russia, much of Africa and parts of Latin America remain locked in this same cycle, he says.
Furthermore, emerging markets are no longer driven by commodities, Brewis says, and are now “arguably inversely” correlated to them. Good news as commodities and inflation subside.
Another factor in the picture is that today’s major emerging markets are considerably more resilient thanks to a better mix of industries: more domestic consumer driven, less commodity and export driven.
In addition, while balance sheets and returns are stable, it appears, Brewis says, that “cashflow is much stronger than it was in the past”, which is good news as it means the next phase of growth can be more easily financed in most emerging markets. This offers a positive outlook – and one again far removed from a debt crisis.
Another factor is how developed market events continue to have an impact on emerging markets, according to analysis undertaken by Franklin Templeton. Although this trend is always going to be a factor given the power between the two markets.
The main influence has nevertheless been persistent inflation and what this would mean for future monetary policy tightening, as well as recessionary fears in the US and Europe. Amongst the high levels of uncertainty, investment-grade emerging market debt returns year-to-date are above those recorded by high-yield issues: investors’ “flight to quality” says Nicholas Hardingham, director of emerging market debt at Franklin Templeton, “results in a stickier, more supportive investor base for higher-rated bonds”.
In this scenario on-going concerns about a global growth slow- down and tighter liquidity conditions have expedited another wave of outflows from emerging market debt and may limit the scope for fund flows into the asset class for the remainder of 2023.
Developed versus emerging
Comparing the wider macro-economic outlook of developed and emerging markets makes interesting reading when consulting the IMF’s latest predictions. It says gross domestic product growth in advanced economies will slow to 1.3% in 2023 and pick up modestly to 1.4% in 2024.
The outlook for emerging market economies is stronger over the same period, with a growth rate of 3.9% in 2023, followed by an increase to 4.2% in 2024 .Greg Smith is also bullish. “2023 is set to have the strongest growth versus advanced economies for 13 years,” he says. Which could lead to the question: emerging market debt crisis – what crisis?
Emerging market securities attracted around $10.4bn (£8.1bn) in May, according to the IIF. Hardly the sign of a crisis, but… “While our data shows a positive picture overall, this is the fifth consecutive month of China debt outflows and only marginal China equity inflows,” says Jonathan Fortun, an economist at the organisation.
Inevitably, the wider global macro-economic outlook plays its part. Fortun adds the IIF maintains a view of lower inflation in the coming months for the US and a controlled landing of the economy, which may benefit emerging market flows overall. “Emerging market local bond valuations have showed notable resilience this year, as slow growth and broad dollar weakness are driving returns,” he adds.
“Sentiment toward emerging market local government debt has lost momentum, returns are sliding back into negative territory,” Fortun says. “Nevertheless, we see an important rotation out of China debt. May’s data shows an outflow of $7.2bn (£5.6bn) in China debt securities, making this the fifth consecutive month of outflows.”
Fortun adds that term premiums have tightened sharply across emerging markets. “Yet as central banks shift their focus to growth from inflation, we see an opportunity for investors to take advantage of the context by receiving in the front end of local yield curves, which has benefited emerging market debt flows overall,” he says.
Good shape
Fundamentally though, despite talk of a debt crisis, emerging markets remain in good shape with little deterioration in their creditworthiness, even as spreads widened significantly during the sell-off in 2022.
In this context, Hardingham remains “particularly focused” on attractively valued securities from issuers with “solid underlying fundamentals” and enough of a “buffer to withstand a period of higher global rates and/or loss of market access.”
He also sees “some compelling opportunities” within the local-currency universe, particularly where higher nominal yields compensate for potential foreign exchange volatility, as well as amongst those currencies that have a lower correlation to the broader market.
Smith offers an even more positive outlook. “Emerging markets are the engine for global growth at the moment, while recession risks loom in the UK and USA.” But to take advantage of any opportunities, rigorous research is necessary.
“Emerging markets are no longer a simplistic unidimensional thematic asset class,” Bisat says. “Indeed, the new emerging market paradigm requires numerous asset allocation and bottoms-up security selection decisions.”
Yet a debt crisis is something investors should not worry about in emerging markets.
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