Risks in many emerging markets (EMs) are driven by political instability or high external vulnerabilities, meaning there is little scope for systemic crises. Given this outlook, we believe there are opportunities in EM debt markets in Africa, the Middle East, and Ukraine.
Outlook Constructive
Our broad outlook for EM debt is constructive. The global economy is improving, global trade is picking up, commodity prices are rising—and all of this is happening in an environment in which global liquidity conditions remain supportive.
There is also very strong multilateral and bilateral support for EM countries through International Monetary Fund (IMF) programs and debt-service suspension initiatives. The increase in the IMF special drawing rights allocation will provide significant additional support, especially for middle- and low-income countries.
In this overall context, default risks should remain well contained.
Inflation Worries?
That said, some investors are concerned about inflation. We are seeing central banks raising rates in some countries, including Mexico. And what will happen when the Federal Reserve tightens monetary policy? Will we see something akin to the 2013 Taper Tantrum that negatively impacted emerging markets?
Rising inflation is certainly a top-of-mind concern for investors. We believe, however, that higher inflation will prove transitory once base effects and supply bottlenecks start to dissipate. Our base-case scenario contemplates a very gradual monetary normalization process in advanced economies. In emerging markets, significant economic spare capacity should limit the need for an extended monetary tightening cycle.
We expect global inflationary pressure to be transitory as we work our way through a major supply shock and a sharp rebound in commodity prices. In Mexico, Banxico is doing the right thing and balancing the need for expansionary policy to support the economic recovery with managing longer-term inflation expectations. Examples of other countries taking similar steps as Banxico are Russia, Brazil, and Hungary. Should inflation prove stickier than expected, we’ll likely see further tightening with real rates above those of developed markets.
In the United States, several differences should limit the impact of tightening relative to 2013. Investor positioning in EM debt and currencies is much lighter and less concentrated. External balances and buffers are much stronger, the global economy is more in sync with the United States, and monetary policies are moving in similar directions.
Opportunities
Given this background, we see compelling opportunities for EM debt investors in certain countries.
In the external credit space, we prefer high-yielding countries with low near-term refinancing needs and strong multilateral and bilateral support. We also like countries where improvements in terms of trade are supporting the economic outlook.
In Africa, for example, opportunities like these include Angola, Gabon, Cameroon, and Egypt. In the Middle East we like Oman and Bahrain. We also are positive on Ukraine, where we see continued prospects for an IMF disbursement this year.
In the local currency space, we like places such as South Africa, Brazil, and Mexico. The credibility earned by these countries’ central banks will help anchor expectations and cushion potential second round effects from higher energy and food prices.
We also like Pemex (PetrĂłleos Mexicanos) local debt because of higher oil prices and our expectation for continued government support.
Although South Africa has entered another lockdown phase, there has been very little correlation between EM currency performance and COVID-19 outbreaks. Improved terms of trade have been supportive of the South African rand over the past year, and the current account is now in surplus. However, positioning in the rand is now very heavy and the currency is at risk of reversal if risk global sentiment deteriorates or we see a prolonged period of U.S. dollar strength.
Risks
We are cautious about a small number of countries that have high external vulnerabilities, where investor positioning is heavy, or where there is heightened political risk: Turkey, Belarus, Colombia, and Peru require close attention. Presidential elections in Brazil next year are also a reason for concern.
Lastly, we are cautious about Argentina, where we see a very challenging fundamental backdrop. That said, the overall debt-servicing picture has been helped significantly by the recent restructuring. Thus, any progress with creditors such as the Paris Club is good news. Here, we have a preference for provincial debt where we think the risk/reward profile is better compared to the sovereign debt.
It is important to notice, however, that these are idiosyncratic risks. We do not see the scope for a systemic crisis in EMs. Growth is improving, fiscal and debt dynamics stabilized, external accounts remain healthy, and the financial sector is well capitalized.
Marcelo Assalin, CFA, is a portfolio manager on and head of William Blair’s Emerging Markets Debt team.
