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    Emerging market debt: no more tantrums?

    Emerging market debt: no more tantrums?

    December 16, 2021 Fixed income

    Emerging market debt (EMD) was vulnerable during the Federal Reserve's (Fed's) last spell of 'tapering'. By contrast, today's EMD market looks not only more prepared, but laced with selective investment opportunities.

    Summary


    US 'tapering' is now a manageable risk for EMD

    History is unlikely to repeat itself in the near future, in our view

    In November 2021, the Fed once again enacted a ‘taper’ of its asset purchases from one of the largest quantitative easing (QE) programs to date. As they reduce its scope, many investors may wonder if a 2013-style ‘taper tantrum’ awaits risk assets, such as EMD.

    In our view, the answer is ‘no’. The Fed’s current trajectory may even present opportunities for nimble and sophisticated EM investors.

    Re-visiting the 2013 'taper tantrum'

    In May 2013, the Fed announced that it would be prepared to “increase or reduce the pace of its purchases” under its third QE program. Investors worried that a key force that had pushed flows into higher-yielding assets, including EMD, was about to reverse.

    Markets reacted wildly. The US dollar currency index appreciated 3.5% within two weeks. Four months later, the 10-year US Treasury yield had almost doubled (from 1.6% to 2.9%1).

    In EM, local currencies depreciated, making hard currency debt tougher to service. EMD spreads spiked as investors rushed for the exit. The ‘Fragile Five’ – Brazil, India, Turkey, Indonesia and South Africa – were particularly hard-hit, given their dependence on EM flows.

    The stress was exacerbated by the existence of twin deficits (current account and fiscal deficits), low carry, dovish monetary policy and rising passthrough inflation risks from weakening currencies.

    EM central banks are already hiking — creating a substantial 'cushion', unlike 2013

    While the US has slowly ‘crossed the Rubicon’ into reversing its monetary policy expansion, EM central banks are ahead of the curve. Many have already substantially raised rates to contain inflation (see Capturing inflation-related opportunities in emerging markets), whereas most were cutting rates in 2013 (Figure 1). The sample below have collectively raised rates by over 12.5%.

    Figure 1: Unlike in 2013, EM central banks have more room to cut rates2

    This hiking activity has helped anchor inflation expectations in many EM regions, reducing the risks of capital outflows and financial instability. Rising rates has widened the yield premium in EM relative to developed markets. It has also added monetary firepower, which central banks will eventually be able to deploy through renewed easing faster than developed markets once inflation pressures recede. For example, we believe Russia could be the first to begin cutting in 2022.

    Of course, not every country has been hiking. The most obvious example has been Turkey, which has been loosening policy, very similar to the period preceding May 2013, resulting in 2013-style performance of the Turkish lira, which has depreciated close to 25% in 20213.

    Elsewhere, many EM local currencies are relatively attractive in our view, in contrast to 2013, offering a valuation ‘cushion’ against global volatility (Figure 2).

    Figure 2: Real effective exchange rates offer greater relative value today4

    We see a similar dynamic of cheapening valuations within EM high yield sovereign credit spreads (Figure 3).

    Figure 3: EM government and corporate valuations are compelling on a historical basis, in contrast to 20135

    EM investor positioning is far less crowded than in 2013

    In 2013, EM allocations were close to maximum levels, leaving the market vulnerable to a negative catalyst like the ‘taper tantrum’.

    The Mexican peso is often considered a good proxy for market positioning, given its convertibility, 24-hour trading and ample liquidity. Investors were ‘net long’ in 2013 but are ‘net short’ today, essentially ‘hedging’ against an EM sell-off on average (Figure 4).

    Figure 4: Investor positioning in emerging markets looks far more conservative today6

    The pandemic was also a major factor in ‘washing out’ long EM positions given the degree of outflows in 2020 (Figure 5), and a rebound to ‘crowded’ positioning (similar to 2013) has not occurred. Investor surveys also show the smallest allocation to EM sovereigns and local rates positions since at least 20187.

    EM fundamentals include external buffers

    Several EM countries have improved external accounts following the harsh lesson of 2013. Of the sample below, only Columbia (roughly 2.5%-4% of EMD indices) is worse off (Figure 6).

    Figure 5: Almost all EM countries have improved current account positions8

    Select EM countries also have higher currency reserves today, like India, where the central bank has almost doubled the nation’s reserves since 2013, providing greater ability to defend their currencies in the event of material outflows. In the event financing becomes tricky for sovereigns in the near-term, higher reserves would also provide some relief.

    Although EM sovereign debt loads are significantly higher than in 2013, in our view this is partially compensated by valuations, improved external accounts, increased FX reserves and access to multi-lateral financing in numerous instances.

    Global liquidity will remain supportive of EMD for some time

    Markets now have previous lived experience of a US ‘taper’. After initiating the ‘taper’ in December 2013, the Fed only ceased new QE purchases in October 2014; however, it was not until 2017 that it would even begin ‘contracting’ its balance sheet.

    The Fed is currently on schedule to finish ‘tapering’ in 1H 2022 after which the next frontier will be a ‘lift off’ in interest rates. It may be some time yet before the Fed’s balance sheet contracts from its record levels.

    Further, whereas the 2013 ‘taper talk’ came as a shock to investors, the Fed has been much more careful in its guidance throughout 2021. Even once the Fed finishes ‘tapering’, due to the sheer size and scale of the global monetary response to COVID-19, liquidity will remain at unprecedented highs for some time yet (Figure 7).

    Figure 6: Global liquidity will remain at unprecedented highs for some time9

    US policy is less of a ‘threat’ to emerging markets

    EM countries have access to diversified sources of global liquidity, including the increasing support from supranational agencies. For example, the IMF, in August, approved a general allocation of Special Drawing Rights (SDRs) equivalent to US$650bn to help boost global liquidity. Many EM countries have since generally seen an increase in SDR allocations between 0.2% and 1.5% of GDP9. Multilateral agencies have also shown a more sympathetic approach to conditionality post-pandemic emphasizing growth recoveries.

    Similarly, US real yields are much lower today given the current level of inflation and accommodative policy rates, indicating that even with ‘tapering’ there is still some way to go before US rates ‘reprice’ upward to levels that would be disruptive to emerging markets from a real yield perspective (Figure 8).

    Figure 7: Ex-ante real yields are materially higher in most EM countries than in the US10

    The outlook for EM is selectively constructive as 'tapering' begins

    Inflation will likely determine the direction of rates

    Markets are currently pricing in further rate hikes across EM as a result of inflation pressures (see Capturing inflation-related opportunities in EM). This is because inflation, as in the advanced economies has been lifted by supply chain issues and higher energy costs. This has left markets concerned about a resultant drag on growth across EM. If, however, global inflation forces moderate or recede (which we see as a real possibility), this would be a economic tailwind.

    Risks from China are at least partially ‘priced in’

    The China question remains key for emerging markets given downward growth revisions for 2022 and increased regulatory scrutiny of select business sectors including the property sector risks highlighted by Evergrande. These headwinds have led to central banks revising their forecasts to reflect lower EM growth.

    However, in our view, markets have significantly repriced the risks of Evergrande’s woes leading to wider financial sector turmoil within China. Chinese high yield property spreads have widened considerably. On the positive side, if Evergrande undergoes a contained and structured default process, we believe this, in addition to policy support (eg loosening mortgage conditions for home buyers, easing domestic channels of financing for corporates, etc.) could potentially even leader to a ‘relief rally’ in EM. For that to come to fruition, we believe we need to see more decisive policy stimulus from Chinese authorities.

    Although downgrade to China’s outlook have weighed on broader EM sentiment, including asset class flows, we expect divergent outcomes for EM in 2022 based on a countries’ domestic policy mix and their sensitivity to China’s economy.

    Three ideas for playing emerging markets as the US tapers

    1) Select high yield sovereigns and corporates

    We see counties such as Egypt and Ghana as particularly interesting given their respective 2022 growth outlooks of 5% to 6%.

    Ghana’s spreads have lagged despite presenting a 2022 budget targeting 5% fiscal consolidation (albeit with implementation risks) and supportive terms of trade (given their ability to export oil and gold). Ghana recently tightened monetary policy by hiking 100bps to tackle inflation and provide attractive real yields to retain local bond flows.

    Egypt’s spreads have also lagged due to hard currency outflows and overweight market positioning. We believe Egypt will benefit from a technical perspective to start 2022 as its local bonds are set to enter the GBI-EM local bond index and will attract passive bond flows. Egypt also recently graduated from an IMF program and retains close links in case of future financing needs.

    We also see value in selective EM corporates, particularly in LATAM where political risks have cheapened valuations and corporate level deleveraging trends and low default rates have made for strong fundamentals. Compelling opportunities may arise where depreciating local currencies can help commodity exporters.

    2) EM local currencies

    Given the mixed economic picture across the globe we see several opportunities for tactical local currency alpha trades.

    For example, we see potential value in a long position in the Indian rupee (INR) versus a short in the Indonesian rupiah (IDR). The former has suffered at various points in the year (given India’s painful wave of Covid cases). However, India is now on a recovery path with mobility indexes exceeding pre-pandemic levels and growth revisions higher for 2022, unlike most other EM countries.

    Conversely, the IDR has outperformed on bond inflows and its central banks quantitative easing. We believe it is prone to reprice from increasing US Treasury yields and from China’s regulatory stance on coal prices impacting Indonesia’s trade balance outlook.

    3) Local EM rates

    Inflation has led to higher yields and flatter yield curves where the central banks have been aggressively tightening policy. Elsewhere In countries where interest cycles are not as mature, curves have steepened.

    In regions with relatively flat curves such as Mexico and Russia, we believe investors can benefit from compelling ex-ante real yields and the potential to benefit from future easing should inflation recede or from excess hikes priced not materializing. We expect shorter maturities (5 year) to outperform on the curve.

    Where curves have steepened, we see opportunities for investors to benefit from capital gains from ‘rolling down’ the curve provided curves remain steep. Examples include long-dated South Africa local bonds given benign inflation risks.

    In countries where the risks of a more persistent inflationary environment exist because of strong growth and tight labor markets, we believe active underweight positions can offset long rates exposure to reduce portfolio risks. For example, we have held underweights in Poland, Czech and Hungary throughout 2021 anticipating faster closure of output gaps and given their correlation to Treasuries. As their hiking cycles mature, we will begin to cover the under-weight.

    We believe a selective strategy as described can potentially benefit investors whether global inflation proves persistent or ‘transitory’ (see Instant Insights: Stubborn but stabilizing). If persistent, we expect steep curves like South Africa to flatten from ongoing monetary tightening. If ‘transitory’ (our base case) we expect excess hikes priced by the market in places like Mexico (250bp hikes over 12 months) to partially unwind.

    Implementing the full 'toolkit' to target value in emerging markets

    We believe managers with specialized capabilities in local government, rates, hard currency corporate and sovereign credit, and FX will be best placed to extract these EM opportunities.

    Investors require tools, including derivatives instruments to efficiently execute long, short and relative value positions. ‘Top-down’ and ‘bottom-up’ capabilities are also essential.

    Given the sheer scope of emerging markets, investors also need to consider:

    • The reaction of real yields to inflation surprises
    • Individual central bank reaction functions
    • The efficacy of monetary policy within an economy
    • Sensitivity of foreign currency shifts
    • Current account and trade balance dynamics
    • Inflation forecasts versus market pricing

    In our view, the current environment of differentiated profiles in emerging markets offers a wealth of potential for skilled EM investors to capture returns from idiosyncratic market opportunities.

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