The response from global central banks to the current health and economic crisis has been impactful and broad based. It is thanks to the large number of proactive central bank measures, from the Fed, in particular, that we’re not dealing with a deeper financial crisis. The response from the Fed has been huge, but it’s also proportional to the risks being faced. We have seen interest rate cuts and quantitative easing (QE). These have been important, but there have also been a number of measures specifically to help the functioning of capital markets in US Treasuries, the repo market, the corporate bond market, and even some parts of the sub-investment-grade market. For example, supporting “fallen angels” (bonds that were previously investment grade but have been downgraded to high-yield status). Central banks have been pivotal in supporting market pricing during this unprecedented time.
Emerging markets (EM) are not all the same
EM, taken as a whole, are a small net exporter of commodities and hence could suffer from a collapse in commodity prices. However, it is important to consider the large divergence between and within regions, as well as that within commodity categories.
Europe, the Middle East and Africa (EMEA) is a commodity net exporter, with the Gulf Cooperation Council, Sub Saharan Africa and Russia all major energy exporters. Latin America is also a net commodity exporter but relies more on agricultural products and metals than energy. In contrast, Asia is a net importer of commodities and so is in a relatively better place to weather the current weakness in energy prices.
The EM countries that appear most vulnerable to weak commodity prices from a fiscal standpoint include Ecuador, Colombia, Angola and Nigeria. The oil prices needed to balance the current account appear to be particularly high for Colombia and Kazakhstan. Meanwhile, countries like India, Pakistan, Thailand, Sri Lanka, Turkey and South Africa may benefit. Very broadly, lower oil prices tend to have a net positive impact on many EM local-currency issuers through lower inflation and an improvement in fiscal and external accounts, although this may be a more medium-term factor. Some diversified mining countries, such as Peru, have managed to avoid a significant downturn. Agricultural commodities have held up well, supporting Paraguay and Uruguay.
A weakening US dollar could benefit EM debt
The large liquidity injections by the Fed may in time lead to a weaker US dollar, and we’ll likely need to see a broad-based recovery in global growth before we see a decisive turn in the dollar. In the past, a weak US dollar has generally tended to have a positive impact on EM for several reasons. The main one being that most EM countries meet at least part of their borrowing needs in US dollars. They do this for a number of possible reasons: EM capital markets are generally less developed than developed markets (DM) markets; global investors may not lend to them in their local currency; and interest rates are lower in the US (although issuers need to pay a spread over US Treasuries). When the US dollar weakens, EM countries’ external debt levels and interest payments fall, while the reverse happens when the dollar strengthens. Over the past couple of decades, EM governments have started to issue more debt in their local currency, although corporate EM debt is still predominantly issued in US dollars.
Secondly, the US dollar has tended to weaken relative to EM currencies when there has been broad-based global growth. Stronger global growth also supports commodity prices, which is another benefit to EM.
Finally, the combination of these two factors – a lower external debt burden and broad-based growth – is very supportive of a fall in the risk premium of emerging market debt from the perspective of global investors. This supports foreign direct investment flows.
The long-term outlook for EM debt
It is very difficult to time the bottom of the market, but although there are risks inherent in investing in EM there will always be opportunities within this asset class for research-based investors. One example currently is EM hard currency debt. Credit spreads on EM US dollar bonds remain elevated, trading just above 500 basis points (bp) over the risk-free curve, compared to below 300bp earlier this year. However, this premium over US Treasuries hides two very different sub sectors. EM investment-grade US dollar debt has been trading at the low to mid 300bp over US Treasuries, whereas the high-yield segment has been trading around 1000bp over, which is a spread of around 250bp over their US dollar corporate high-yield counterparts (as at 18 May 2020, sources: JPMorgan, Bloomberg).
Opportunities in EM debt can be found throughout the cycle. While factors such as risks, valuations and economic growth projections vary over time, there are a number of reasons to consider investing in EM debt over the long term.
As economies mature, a long-term investor can benefit from the improvement in credit ratings as EM economies transition into a more developed-market-like economic structure. There is evidence for this in parts of Asia and Eastern Europe. When this happens, credit spreads of hard currency bonds have tended to narrow. With local currency bonds, there is plenty of scope for both real and nominal bond yields to fall and converge with yields in developed bond markets. This is because many nations are now better equipped and more willing to bear down on inflation than at any point in their history, be it through monetary policy, deregulation or labour market reform. Meanwhile, there are reasons why currency appreciation could, once again, potentially be a key source of return for local currency bonds in the longer term. Emerging markets’ rising productivity and growth relative to the developed world, their improved terms of trade and their exposure to rising global commodities could serve as a magnet for investment inflows over the medium to long term.
Regardless of an investor’s approach to investing in EM debt, it is worth considering diversifying according to credit rating, region, market size and economic drivers. For example, having oil importers as well as oil exporters in a portfolio. An active research-driven approach to the sector is key.
James Blair is a fixed-income investment director at Capital Group.