Outlook 2023: Paul McNamara (Emerging Market Debt)

The key issue for the asset class has been the combination of higher US rates (especially via the stronger US dollar) and higher inflation. The best scenario for EM debt is trend or better growth across the world.

December 2022

A miserable year for emerging market (EM) debt has been driven by currency (-8.7% as of 30 November 2022) and weaker bonds (-11.9%) although higher carry has slightly mitigated the issue (+4.5%).

Rates and yields are high at present, and at a minimum, currencies are cheaper than they have been for years, at least versus the US dollar. Emerging currencies have traded against a strong dollar in line with the historical relationship – when the dollar rises 1% against developed markets, it rises 1.4-1.5% against EM.

There are a number of reasons for the dollar’s extraordinary strength this year: the Federal Reserve moving more aggressively than its peers, a defiantly robust US economy, fallout from the Russian attack on Ukraine that falls disproportionately on Europe and a Chinese economy which has suffered from a series of strict lockdowns in pursuit of zero Covid. EMs tend to do best in a world with broad strength in economic growth, whereas a “unipolar” world with only the US prospering tends to simply mean a strong dollar. Commodity exporters are especially reliant on China.

In 2023, we expect to see a change in these relationships, but it is far from clear yet exactly how. The best case would be a soft landing in the US, with inflation coming down without a serious recession, combined with a mild winter in which Europe does not run out of gas and a relaxation of China’s draconian interest rate policies. In such a case softer oil and global food prices could take the sting out of EM inflation while a weaker dollar would allow EM currencies to claw back lost ground.

The fall in commodity prices at the end of 2022 offers hope for EM inflation into 2023, but the lags have historically been short and the failure to respond so far causes concern. Some of this can be explained by coverage – the index does not cover the natural gas prices which are so important in Europe and which have fallen more recently than most other prices. But it is a struggle to depict this as more than merely the most likely of a number of possible scenarios. Similarly with external trade, the higher oil price has weakened external balances and the retracement will help.

However, when EM does best (see 2000-2006 or 2009-10) the balance of payments surplus is such that governments usually intervene in currency markets to prevent excessive appreciation. This is not the case at present. While EM weakness or strength tends to be self-sustaining, it is hard to be optimistic with such a trend.

Overall, the outlook is very dependent on the winter in Europe. Gas prices have retraced most of their autumn panic, but at least part of this drop is because Europe has successfully filled its storage, and demand will be weak until the gas has been drawn down. Much of Europe has very limited storage relative to usage, and a number of countries will likely run out of gas if there is a cold winter. This would have serious consequences for the European economy (and would likely result in sharp dollar strength and EM weakness). The consequences for Central Europe could be especially bad.

In summary, we are cautious about pushing an all-round bullish view on EM. This would involve a ‘soft landing’ in the US, where the tightening done to date, plus a very small number of further hikes, is sufficient to take the momentum out of inflation without tipping the US into a serious recession (a technical recession of two quarters of negative growth looks very likely nonetheless). In case of a soft landing in the US, and a benign recovery in the rest of the world, EM currencies begin to look rather attractive. Absent such certainty, and with our usual metrics of EM currency demand and valuation (current account/trade balances, growth in currency reserves) looking fair value at best, we are neutral on EM currencies.

However, EM bonds look far more compelling. Rates have risen as much or more than in developed countries; inflation is more sensitive to volatile commodity prices and looks well placed for a sharp drop. EM bond prices have been far more likely to decouple from currency rates – most clearly seen in 2008, when yields fell sharply (amid the collapse in oil and other commodity prices) despite weak currencies.

Our particular favourites are the countries where central banks have hiked rates relatively aggressively. Chile and Brazil have already demonstrated the returns from bonds as the cycle turns can be large. Hungary and Colombia are the two most likely candidates to follow, though both have serious question marks (policymaker commitment in Hungary, fiscal and balance of payments vulnerabilities in Colombia). We also continue to like long-time preferred markets like Mexico, South Africa and Brazil. We are cautious about countries we regard as vulnerable (Turkey, Egypt, Ukraine) and also generally in Asia, where rates have risen less and inflation has been suppressed by expanding (expensive) subsidies.

Turning more bullish, the best scenario for EM is trend or better growth across the world. This means, apart from avoiding US recession, avoiding persistent zero Covid lockdowns in China and a gas-related accident in Europe. The best confirmation signal would be stabilisation or even recovery in EM reserve levels. Some combination of these factors would allow us to turn more bullish on EM currencies, which would support the appeal of bonds as well as generating returns in its own right. When the market turns, the returns may be strong – technicals are positive, sentiment is bearish and investors are underinvested (whereas investors are long the US dollar while lacking conviction).