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2022 has been a turbulent year for the capital markets, with many investors struggling to reconcile rising inflationary pressures, a commodity price surge, a faster pace of interest-rate hikes, economic recession concerns, and a host of geopolitical risks.
While global inflation is likely to remain elevated, we expect it to plateau in 2023 and then gradually decline from those levels as tighter financial conditions and easing supply-chain bottlenecks begin to take hold. Global growth is starting to cool as fiscal stimulus tailwinds wane and higher rates restrict lending activity. The pace of developed-market (DM) rate hikes should slow going forward, but their central banks’ withdrawal of monetary-policy stimulus is likely to continue over the near term. China may provide a boost to global growth as its key cities emerge from COVID lockdowns, though it remains to be seen if the country’s “zero-COVID” stance will persist through any future virus flareups. Russia’s steadfast commitment to the ongoing war in Ukraine likely will keep energy prices high, particularly in Europe.
This confluence of macro factors has challenged EM economic growth, which had been broadly benefitting from a recovery in global demand as most economies reopened from COVID. Like elsewhere, the global energy and food price shock has pushed overall EM inflation higher. The “terms of trade” commodity price shock is a positive for commodity-exporting EMs, but a negative for commodity importers.
Some EM countries are in a better position to weather these difficulties, given their stronger fundamentals and easier access to financing. Others, however, are facing higher debt burdens and domestic policymakers that have limited room to maneuver at this juncture. National election cycles will be another variable to monitor closely as they can impact both political stability and prospects for economic recovery in DMs (e.g., the upcoming US midterms), as well as in key EM countries like Brazil and Turkey. This uncertain global backdrop has created an extreme amount of credit spread dispersion across individual countries (Figure 1) which we see as an attractive opportunity that favours active investment management.
Signals we are watching to potentially turn more constructive include easing geopolitical tensions; moderating inflationary headwinds; monetary policy reaching terminal rates; and growth in China perhaps beginning to improve. All of these would help reduce the volume of monetary tightening needed and hopefully lessen the damage to global and EM growth.
EM credit spreads in both sovereign and corporate debt have widened alongside other fixed income assets and, after several months of underperformance following Russia’s invasion of Ukraine, have reached levels that may suggest that current valuations more than compensate for the negative shock. These lower valuations could provide opportunities for deep country-by-country analysis and relative value security selection to capitalize accordingly. For example, fundamentals for many EM corporate issuers look particularly strong within the oil & gas, telecom, utilities, and infrastructure sectors.
Most EM central banks were well ahead of their DM peers, having collectively raised interest rates significantly as of this writing, thereby helping to lift EM local-market yields to attractive levels. The rate-hiking cycle has been unexpectedly extended by the inflationary impact of the Russia/Ukraine conflict. Country differentiation remains important here, as monetary policy responses have varied, with some EMs nearing the end of their hiking cycles (e.g., in Latin America). As global economic activity begins to normalize, fiscal stimulus measures fade, and central banks withdraw liquidity, inflationary pressures should start to subside. This would allow EM policymakers greater latitude to stabilize rates before shifting to an outright easing cycle, particularly considering the economic slack present in many EM economies.
On the EM currencies front, we have observed several crosswinds at play, including US dollar (USD) upward directionality and interest-rate volatility on the back of many investors’ flight to perceived “safety”. Over the longer term, we anticipate that proactive actions by many EM central banks and a wider US external trade deficit (the EM trade balance has rapidly shifted to deficit over the past 12 months) likely will help bolster EM currencies.
Lastly, technicals in EM local markets indicate that they are generally under-owned by foreign investors, suggesting less demand amid more muted supply. In EM credit, new issuance has been well below historical averages and is expected to remain subdued. While supportive, this decreased supply also diminishes liquidity, leading to wider bid/offer spreads. Investor outflows accelerated in the third quarter but have recently shown signs of slowing. Hard-currency funds have experienced higher outflows and lower levels of crossover interest, while local outflows have been dominated by regional allocators.