Executive Summary
As we enter the second quarter of 2022, new uncertainties arising from the war between Russia and Ukraine were reflected in widening bid/offered spreads for the EMBIG-D index, presenting certain challenges for our valuation metrics. As with the sudden arrival of Covid-19 in 2020, underlying sovereign credit fundamentals in our metrics are in flux, suggesting caution in interpreting the results. Like Covid-19, much of the uncertainty has to do with the duration – in this case – of the war. The longer the war and resulting supply shocks, the more durable the fundamental shifts, which to date have favored commodity exporters and hurt importers, as they have certain tourism-dependent countries.
- External debt valuations appeared to improve as widening spreads have not yet been offset by higher expected credit losses. As in the acute initial phase of the Covid crisis, where ratings agencies lagged in downgrading credits, the sudden change in environment will likely result in ratings actions of an uncertain net magnitude. Thus, we caution interpreting the high credit multiple as an unambiguous buy signal. Meanwhile, the sharp rise in U.S. interest rates has improved the level of rates; however, a flatter and now inverted yield curve also suggests caution in extending duration.
- Within local debt, the picture is muddied by the expulsion of Russia from the GBI-EMGD index and the higher inflation environment. At the start of the quarter, Russia represented 7.2% of the GBI-EMGD and offered a very attractive FX valuation. At the end of the quarter, EM FX valuation is weakened by the rise in the inflation expectations but supported from a pure valuation and balance of payments perspective, ending at the lower end of the neutral range. In rates, new uncertainties around the length of inflation spikes challenge our real rate estimation; certainly, nominal rates have adjusted higher quickly, but so far, not by enough to overcome higher inflation forecasts. Having said that, the real yield differentials between EM and DM rates remain wide to offer, on balance, a mild to attractive picture for EM local debt.
In this piece, we update our valuation charts and commentary, with additional detail on our methodology available upon request. 1
External Debt Valuation
The EMBIG-D benchmark spread widened by 31 bps in Q1, ending the quarter at 400 bps. As seen in Exhibit 1, the fair market multiple is the benchmark’s credit spread to the spread that would be required to compensate for credit losses. This ratio rose over the course of the quarter. The multiple stood at 3.0 on March 31, 2022, up from 2.8 on December 31, 2021. We estimate the credit multiple threshold range by analyzing the relationship between the subsequent two-year EMBIG-D credit spread returns and the credit multiple historically. A level that is higher than the upper range of the threshold (currently 2.8) has historically been associated with positive credit returns, while a level below the lower range of the threshold (currently 2.0) is associated more with negative credit returns over the next two-year period. This threshold range estimate is recalibrated on an annual basis. A level within this range would be considered neutral, and the market valuation ended the quarter above the upper end of this neutral range.
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