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Sydnee Gatewood
Sydnee Gatewood
Articles (3566) 

William Blair Commentary: Emerging Markets Debt Well Supported

By Marcelo Assalin, CFA

February 25, 2021 | About:

After an extremely challenging 2020—a year that will go down in history as one of the most difficult periods in modern times—we expect a strong global economic recovery in 2021, as already indicated by the rapid rise of Purchasing Managers' Indices (PMIs). While the recovery has been led by robust economic growth in advanced economies and China, EMs should also benefit from improving global trade, rising investments, and higher commodity prices.

However, the path to economic normalization is more uncertain and will most likely be more uneven than in developed markets.

Vaccine production constraints and distribution challenges mean rollout programs should be delayed in many of the smaller, less wealthy EMs. As a result, virus containment measures will have to remain in place for longer. This could delay the economic recovery. However, there are nuances. Countries with younger demographics, for example, have been able to soften lockdowns as hospitalization rates have not spiked.

Asian, Central European, and Eastern European countries should lead the recovery, driven by better management of the pandemic and stronger fiscal buffers. Middle Eastern, African, and Latin American countries are likely to be the laggards, affected by structural headwinds and lack of additional fiscal capacity.

Signs of Stabilization Despite Fundamental Deterioration

While we expect the average real GDP growth in EMs (as represented by the countries in the J.P. Morgan EMBI Global Diversified) to rebound to 4.7% in 2021 from -4.8% in 2020, overall levels of output should remain below those of 2019. On the other hand, large output gaps should help keep inflation subdued over the near term.

The severe impacts of the COVID-19 crisis on economic activity and fiscal revenues will likely continue weighing on fiscal accounts, most notably in countries that also implemented fiscal stimulus. Although we expect the average fiscal deficit-to-GDP ratio to improve to 6.3% in 2021 from 8.5% in 2020, we believe it will remain significantly above the 3% level seen in 2019.

This significant fiscal deterioration has led to increased debt. The average total public debt-to-GDP ratio is expected to increase to about 62% in 2021, from 60% in 2020 and 48% in 2019.

Even though credit metrics have clearly deteriorated in most EMs, raising the need for fiscal consolidation and structural reforms in many places, overall debt levels remain significantly below those of advanced economies. Importantly, although debt levels have increased, the debt burden should be offset to a large extent by lower financing costs.

On the external balance front, the average basic balance-to-GDP ratio should improve to -0.6%, from -1.5% in 2020. Improving prospects for a pickup in foreign direct investment (FDI) flows, remittances, and tourism later in the year should improve the outlook for EM external accounts over the next few years, eliminating any concerns about EM external accounts.

No Systematic Crisis Brewing

While we acknowledge a decline in sovereign credit quality and view aggregate EM fundamentals with a degree of caution, it is important to emphasize that we do not believe there is a systemic crisis brewing in EMs as a whole.

Historically, EM crises have been driven by unsustainable debt dynamics, currency crises, and/or financial sector disruptions. This is not the case today.

Until recently, EM debt levels have grown only moderately and have been generally concentrated in the corporate sector, primarily in China. Most EM countries have rebalanced their external accounts since 2013's "taper tantrum" and many are now running basic balance surpluses, with improved external accounts, rising international reserves, and undervalued currencies indicating strong external resilience. Importantly, the EM financial sector is generally well capitalized and regulated.

Fundamentals in the EM corporate sector remain strong, especially when compared to those of developed market credit, with net leverage levels significantly lower in EMs. The effects of the events of 2020 varied by sector.

The vast majority of non-financial issuers in the EM corporate debt universe were flexible enough to reduce cost structures and defer investments to adjust to this year's lower cash flows. EM non-financial corporates experienced their trough in fundamental metrics in the second quarter of the year, followed by a significant rebound in the third quarter led by the industrial and commodity sectors.

Although aggregate credit metrics deteriorated in 2020, they appear to be on their way to return to pre-COVID-19 levels in the first half of 2021 given current growth expectations, stringent cost controls, and limited capital expenditures.

For financial corporates, we expect loan growth to accelerate in most major EMs, with the exception of China.

Overall, financing conditions should remain favorable for EM countries and corporates in 2021. Ample global liquidity conditions, low financing costs, and strong support from multilateral and bilateral organizations should limit the scope for defaults.

Still, we also see risks on the horizon, albeit with a low probability of disrupting the secular trend.

Hiccups in vaccination rollout programs are a significant risk because they could delay the economic recovery. Conversely, a stronger economic recovery in the United States, triggering a rapid and persistent increase in inflation, could in turn lead the U.S. Federal Reserve (Fed) to start normalizing monetary conditions earlier than expected, potentially creating market instability. In EMs, we could see our estimates of default probabilities prove unrealistic, and a pickup in sovereign credit events could affect investor sentiment negatively. But these risks are not our base-case scenario.

Technical Conditions Supported by Strong Flows and Low Net Debt Supply

Improved investor sentiment and low global rates support investors' search for yield. That, coupled with attractive EM debt valuations, leads us to expect strong flows into EM debt in 2021.

In a world with close to $17 trillion of government bonds trading with negative interest rates and approximately $4.3 trillion invested in near-zero-yielding money market funds, higher EM debt yields should continue attracting sizable flows into the asset class.

EM debt has attracted, on average, $47 billion of dedicated inflows per year over the past 10 years, according to J.P. Morgan, and current conditions—including favorable valuations relative to developed market credit—suggest that inflows could easily exceed that mark in 2021.

Bond supply dynamics should also remain supportive. This is particularly true in the hard currency sovereign space, where improving fiscal deficits should result in a decline of gross issuance. J.P. Morgan estimates net financing needs (gross issuance minus amortizations, buybacks, and coupon payments) will be about $55 billion in 2021, significantly lower than the $101 billion estimated for 2020.

Meanwhile, for EM corporates, gross supply estimates of $522 billion suggest the highest new issuance year on record, although when adjusting for the expansion of the asset class, yearly issuance is closer to average. In net terms, J.P. Morgan estimates 2021 financing needs of $73 billion in hard currency corporate credit, similar to 2020 needs.

Hard Currency Valuations Compensate for Risk

Valuations in the EM hard currency sovereign space remain attractive, with spreads above long-term averages. EM hard currency sovereign credit spreads[1] to U.S. Treasury yields of similar maturity ended 2020 at 352 bps, marginally above the 10-year average.

EM high-yield spreads, the segment of the market where we see most value, ended the year at 608 bps, approximately 55 bps above the 10-year average. The spread differential between high-yield and investment-grade ended 2020 at 455 bps, approximately 105 bps above the 10-year average.

EM high-yield spreads also compare favorably to developed market credit, trading approximately 250 bps above U.S. corporate high-yield credit, which is 170 bps above the 10-year average.

Moreover, we believe the risk premia in EM hard currency sovereign credit overcompensate investors for default and loss-given-default risks. Historically, credit defaults have been rare in this space, affecting less than 1% of the investable universe per year on average since 1983, according to Moody's. Furthermore, recovery values have historically been high, with investors recovering approximately 50% of their original investments, on average, during this period.

To be sure, 2020 was an exceptional year. A large number of countries decided to either restructure their debt (Argentina and Ecuador) or stop debt services altogether (Belize, Lebanon, Suriname, and Zambia). Although default rates increased materially during the year, recovery values remained about 50% of their initial investments, on average.

Going forward, we expect EM hard currency sovereign default rates to converge back toward their long-term average, supported by favorable financing conditions and strong support from multilateral and bilateral organizations. And if our conservative estimates materialize, the performance of the J.P. Morgan EMBI Global Diversified should be hurt only modesty.

Meanwhile, in the EM hard currency corporate credit space, the availability of financing led to a lower-than-expected default rate of 3.5% and historically high recovery values of 43% in 2020. We expect the default rate to improve in 2021, falling to 2.5%. Comparatively, U.S. high-yield credit experienced a 6.7% default rate with a 16% recovery rate in 2020, and we expect the default rate to be 3% to 4% in 2021.

Undervalued Currencies Should Drive Flows in Local Currency Sovereign Debt

In the EM local currency sovereign space, attractive valuations should be one of the more important drivers of inflows.

Our longer-term currency valuation metrics show Europe, Middle East, and Africa (EMEA) and Latin American currencies undervalued by approximately 10% on average, while EM foreign exchange (FX) in Asia tends to be fair to slightly overvalued.

While we do not expect these valuation imbalances to fully adjust in the near term, they provide additional scope for appreciation before EM policymakers feel the need to lean against inflows through increases in foreign reserves or other measures.

The valuation picture in local rates is more balanced, with the low-beta segment of the J.P. Morgan GBI-EM Global Diversified ending this year with flat, low-yielding curves. Particularly in emerging Europe, real rates have moved further into negative territory on the back of deep monetary policy cuts but surprisingly sticky inflation.

On the other hand, the higher-beta markets in Latin America and Africa still offer a considerable degree of excess term premium, while the carry available in frontier markets is also quite high.

On average, real (inflation-adjusted) rates across the J.P. Morgan GBI-EM Global Diversified universe have fallen but remain positive. This trend also reflects improvement in aggregate index credit quality that came with the inclusion of Chinese government bonds earlier this year and the overall increase in market weight in Asia more broadly.

EM local rates really shine, though, when compared with their developed-market counterparts.

Countries most closely linked to the Eurozone have seen their yield curves pushed to historical lows. Compared with U.S. Treasurys, the overall J.P. Morgan GBI-EM Global Diversified spread is approximately 4%, which puts it very closely in line with the long-term average of 4.3%. This occurred despite a significant narrowing of the inflation differential between EM countries and the United States.

[1] Represented by the J.P. Morgan EMBI Global Diversified.

Marcelo Assalin, CFA, is a portfolio manager on and head of William Blair's Emerging Markets Debt team.

Rating: 5.0/5 (1 vote)



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