What is your New Year’s resolution? I was so busy trying to figure out how to celebrate the New Year in line with ever-changing Covid restrictions that I forgot to make one.
Reflecting on it a few days later, I was thinking of replacing the usual ‘must do more exercise’, ‘must drop a few kg’ with ‘must remember to enjoy simplicity, be grateful and appreciate the beauty around us’ – quite a romantic twist versus the usual script.
We are all programmed to look for certainty, achieve our goals, meet targets and control the outcome. Yet often simply pausing and observing can give us more insight and wisdom. On that note, what insight have we gained from observing the emerging markets’ (EM) performance last year?
In 2020, there were plenty of surprises for investors in EM fixed income. EM corporates delivered much lower default rates than their developed market (DM) counterparts (3.5% for EM high yield (HY) credit versus 7% for US HY), as well as much higher recoveries (45 cents for EM credit vs 28 cents for US HY credit). We also saw positive surprises in the shape of economic recovery, with a dozen of EM countries registering positive growth and a combination of a more cautious fiscal stance and an orthodox policy mix, despite the pandemic.
This has translated into positive returns for investors across the board, from 7.6% for EM investment grade corporates to 2.7% for EM local currency debt. We believe a positive narrative for EM could remain for 2021. Yet we expect the dispersion between EM hard currency and local currency credit to be the largest – in favour of local currency – since the Global Financial Crisis in 2008.
Let’s pause and observe the current state of play in EM. While investors are turning more positive on the region, the list of risks is long: Covid-19 management; the speed of vaccinations; US/China tensions and recent sanctions on Chinese companies; the potential for withdrawal of US fiscal stimulus and a less accommodative Fed resulting from inflation concerns.
Looking at sovereign macro data in EM, one could conclude that the Covid-19 scars are not as visible as in DM. Balance sheet deterioration has been relatively modest compared to DM with only a 9% increase in debt/GDP ratio in EM versus 22% for DM, while EM growth has not been hit as hard as that of DM economies.
Yet for the first time since the Global Financial Crisis, EM currencies are benefitting from robust tailwinds both from the US real rates and positive current account dynamics. Most major EM countries are registering current account surpluses, and in some cases such as India, for the first time in almost 20 years.
At the same time, US 10-year real rates are at their lowest level in history (-1%) while EM real yields are not only positive but close to their highest levels since 2008. In China, for example, the 10-year real yield at +2.8% is at its highest level in the last ten years. This creates fertile ground for capital to flow to EM, particularly local currency markets.
What could derail this positive momentum?
Lack of fiscal discipline and policy credibility is an important factor to consider. However, despite DM setting the example of an expansionary monetary policy, the focus on fiscal prudence remains key for the majority of EM economies, especially in the Asian and Latin American regions. From Mexico to China, debt reduction is one of the stated policy objectives. In some smaller countries like Costa Rica, unwillingness to respect fiscal rule has led locals to refuse to fund the government’s needs. While there are notable exceptions (e.g. South Africa), most countries have so far demonstrated remarkable discipline.
EM corporates have shown even more prudence when it comes to cash preservation and liability management. This has resulted in much lower default rates and better recoveries compared to their US counterparts. Moreover, we expect EM defaults to drop even further in 2021 to 2.5% – below the historical average. While Covid-19 remains a sad reality and many EM countries have fewer resources to accelerate the roll-out of vaccines, economic performance nevertheless continues to surprise investors on the upside.
What about the risk of sanctions against Chinese companies?
The impact of sanctions depends on the level of preparation and severity of the sanctions. It’s once again remarkable how the Chinese government has already taken steps to loosen regulatory requirements, making it easier for local companies to get a listing on the HK Stock Exchange, while continuing to provide access to domestic markets and local banks to accommodate SOE refinancing needs.
What could change our constructive narrative?
We are monitoring the pace of China’s monetary and fiscal policy tightening as well as the pace of spread compression. This time we believe China is leading the way for policy tightening. DM policy makers are ready to “do what it takes and more” to support certain sectors and provide a soft landing for their economies. China, meanwhile, has all the ingredients for a healthy recovery and the focus on deleveraging is likely to shift the policy mix in a tighter direction. The question is how recovery will look in the rest of the world when China picks up the tightening pace.
We also have to acknowledge that the rapid pace of spread compression since last March does not leave investors much room for error.
Yet, on a historical basis EM spreads still look attractive, both on an absolute level and relative to DM, while investors’ positioning remains light, especially in the local markets. Last but not least, the pace of vaccine distribution and its success ratio will dictate the pace of growth recovery.
The new year has not brought us more certainty about the state of global recovery or the end of the Covid pandemic. However, we can observe that the pace of EM recovery, in combination with an orthodox policy mix, US negative real rates and positive EM current account dynamics, acts like a magnet for capital allocation in favour of local currency markets.
Sometimes the search for certainty and deliverables can distract us from pausing and observing the simplicity of the decision at hand. What holds us back is not the lack of certainty regarding future outcomes, but painful memories of past experiences.
This is definitely true when it comes to investors’ experiences in EM local currency debt. My New Year’s resolution is to put those memories behind me.