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The world has changed dramatically since COVID-19 first arrived on the scene back in March 2020. Despite the global pandemic and the myriad challenges it brought, 2020 was, in many ways, a remarkable year for emerging markets (EMs). With 2021 now well underway, Fixed Income Portfolio Managers Kevin Murphy and Michael Henry share their latest outlook on EM debt, framed around three primary vectors: 1) the macro and fundamental backdrop; 2) asset valuations; and 3) market technicals.
Broadly speaking, the portfolio managers are constructive on the asset class for the remainder of 2021. However, country, sector, and issuer selection will be critical to navigating a still-risky EM landscape that remains dependent on continued liquidity support from its developed market (DM) counterparts (Figure 1).
Macro and fundamental backdrop
Our forward-looking views for EM debt hinge largely on the progress of recovery from the dual 2020 shocks of COVID-19 and the decline in oil prices induced by the OPEC+ breakdown. In the months ahead, we think gradually reopening economies worldwide paired with significant amounts of fiscal and monetary stimulus — particularly the extraordinary policy responses by DM governments and central banks (which helped limit the global economic downturn and push asset prices higher) — may provide a generally favorable backdrop for EM debt. It’s also worth noting that, even in the midst of the crisis, many EM countries have been running current-account surpluses, which have helped to offset the drag from their own fiscal spending.
That’s not to say there won’t be bumps and hurdles along the way, especially in the near term as countries grapple with recurring waves of COVID-19 and the new strains and variants of the virus that have surfaced in recent months. Yet, while COVID’s adverse impacts will continue to pose headwinds for the global recovery on multiple fronts, our health care team’s research suggests a pretty high likelihood that the vaccines developed thus far will ultimately be successful. The exact timing of that hoped-for outcome still remains uncertain, but our base case is that most DM economies should be able to reopen (or at least return to a semblance of “normalcy”) at some point in the second half of 2021. For most EM economies, a “lag time” of six to nine months after that seems more realistic as of right now.
Regarding the speed and strength of the recovery in EMs, much will depend on the ongoing effects of the crisis in three key areas: commodity prices, EM remittances, and global tourism. In terms of commodities and remittances, the damage has been less severe than we initially feared and has even given way to a rebound in some cases. For example, commodity prices, most notably oil, have largely come back from their 2020 decline. Meanwhile, remittances back to EMs have proven surprisingly resilient overall and have even been up year over year in many locales. On the other hand, sluggish tourism has clearly impeded EMs’ pace of recovery amid widespread COVID concerns and restrictions and will likely continue to do so for the foreseeable future, particularly in EM countries that rely heavily on revenues from tourism.
On the EM credit side, even after a rally that recouped much of the spread widening experienced in early 2020, we believe valuations on the whole remain attractive on a historical basis, with index spreads still cheap (as of this writing) relative to median levels on a three- and five-year lookback. And they appear even more attractive when compared to credit valuations in DMs, where investment-grade spreads, for example, recently drifted into the tightest decile and high-yield spreads into the tightest 20th percentile.
Turning to local debt markets, there are two components to consider: local interest rates and currencies. On interest rates, global central banks, including in EMs, have delivered unprecedented monetary easing to combat the COVID-19 crisis. That has brought EM debt yields down meaningfully over the past year: The current yield on the EMBI Global Diversified Index, composed of sovereign and quasi-sovereign bonds, was 4.7% (357 basis points in spread) as of December 2020; the CEMBI Broad Diversified Index, made up of corporates bonds, yielded 3.5%; and the GBI-EM Global Diversified Index, consisting of local markets, was at 4.3%. Thus, while EM spreads remain at fairly wide levels, from an interest-rate-cycle standpoint, what we view as the best yield opportunities may have passed for now. There may be some scope for yields to rise in certain local debt markets. For instance, a handful of EM central banks are likely to hike rates in 2021. We will be on the lookout for opportunities to potentially capture compelling yield premiums along the yield curve going forward.
On the currency side, where there has been significant volatility over the past year, the growing realization that EMs would likely avert worst-case COVID scenarios has enabled a strong bounce-back in trade and other activity since mid-2020. As of recently, EM foreign exchange (FX) had risen back more than 10% from its COVID lows and (in our view) may still be a bit undervalued, with room for additional upside versus the US dollar (USD) in the period ahead. That outlook reflects EM currencies’ solid external position in an environment where they can offer material pickups in real yield, along with our expectation for further (albeit slight) weakening of the USD over the course of 2021. From that perspective, we believe EM currencies may be an opportune space to deploy capital (Figure 2).
We also believe technical factors around supply and demand should be a tailwind for EM debt markets in 2021, driven by healthy investor flows into the asset class and moderate levels of new issuance. Indeed, the first piece of that puzzle – inflows – had already started playing out back in mid-2020, when investor interest (and capital) began to return to EM debt. Flows into EM hard-currency (USD-denominated) bonds really picked up in the latter half of 2020 and, by year-end, had more or less regained all of the outflows that had occurred earlier in the year.
By the fourth quarter of 2020, the inflows had expanded beyond just the hard-currency space to also include local-currency assets, resulting in strong momentum across all EM debt that lasted through year-end and has spilled over into the first quarter of 2021: January was marked by very brisk inflows into both the hard-currency and local-currency segments of the market. This is an encouraging trend that, in the absence of any negative “surprises,” should hopefully have some degree of staying power as we get deeper into the year.
On the supply side of the equation, it has been a very active start to the current year, with around US$100 billion (and counting) of newly issued external EM debt to kick off 2021. However, we do not anticipate a sustained supply surge to materialize as the year proceeds because much of the 2021 issues to date have come from EM countries that have chosen to bring forward their new issuance to earlier in the year to take advantage of prevailing low interest rates. In the wake of this first-quarter flurry of new issuance, many countries have now already met their funding requirements for all of 2021 and may therefore not need to issue any new debt until 2022. Consequently, we believe that, on average, net new issuance for the rest of 2021 is going to be flat or perhaps even down (from 2020) as we approach the end of the year.
Barring any unforeseen shocks or setbacks, we believe the combination of improving fundamentals and macro conditions, reasonable valuations throughout most EMs, and supportive market technicals should serve discerning, risk-aware EM debt investors well in the months to come. But there may be sharply divergent recovery paths across EMs, highlighting the importance of selectivity on the part of investors.