It’s been a tough year for emerging markets, which have faced tighter financial conditions and a real estate war between growth rivals Ukraine and China. Bond markets in lower-quality developing countries have been hit particularly hard amid rising interest rates. We spoke to Kay Hay, Head of Emerging Markets Debt at Goldman Sachs Asset Management, and Nick Saunders, Head of Emerging Markets Corporate Debt at Goldman Sachs Asset Management, about the challenges and opportunities for financial markets arising from a new era where easy policy is no more. raise all assets.
What are the main issues facing EM economies?
Kay Hay. Emerging market debt burdens have risen sharply in response to both the pandemic and the cost-of-living crisis, leading to weaker fiscal positions. At the same time, the reopening of these economies and the energy price shock have led to worsening current account balances. Given the weaker growth outlook, it will likely take longer for EM economies to see an improvement in fiscal and current account positions, even for economies that are net exporters of goods.
Against this backdrop, the sharp rise in US exchange rates and the US dollar has raised concerns about external vulnerabilities and debt sustainability, both of which could ultimately threaten economic stability and weigh on EM assets. Given economic concerns and sharp outflows from the asset class, spreads on the external EM debt benchmark have widened significantly this year.
So which economies may struggle to attract capital over the coming year?
Kay Hay. Some low-rated EM economies have already lost access to foreign bond markets, challenging their ability to meet short-term external and fiscal needs and meet upcoming debt maturities. Looking ahead, in terms of foreign exchange reserves relative to external financing needs, Pakistan, Sri Lanka, Bolivia, Argentina, Angola and Egypt are among the most vulnerable. In terms of high debt burdens and high debt servicing costs, Egypt, Ghana, Sri Lanka, Ukraine and Zambia are among the most difficult.
If these economies cannot access capital markets, what are the alternatives?
Kay Hay. The good news is that EM economies have two main alternative sources of funding for global capital markets: bilateral lenders and the International Monetary Fund. The bad news is that securing funding from both sources is difficult. China is a leading bilateral lender to EM countries, particularly low-income countries, but funding from China has slowed in recent years. The G20 countries created a “common framework” for debt relief in 2021, which China joined. However, debt restructuring within this framework has been disappointingly rare.
Do these challenges and vulnerabilities suggest an EM crisis is looming?
Kay Hay. The short answer is no. Our analysis shows that the vulnerability of EM countries is isolated, not widespread. Excluding distressed sovereigns, EM sovereign bond spreads are largely unchanged year-to-date and have outperformed similarly rated US corporate bond spreads. We believe this reflects the economic resilience of middle-income, often larger, EM sovereigns. For example, the five largest external emerging market debt countries by GDP—Brazil, China, India, Indonesia, and Mexico—are not at risk of an external crisis.
Importantly, the risks are largely confined to smaller low-income countries and are already heavily reflected in bond valuations. The risks emanating from the two major sovereign nations at risk, Argentina and Turkey, are also well known and, in our view, priced in. We believe the market will continue to diverge, retaining funding for higher quality (and often larger) holdings with deep trading. and global financial linkages. In other words, we do not expect contagion from pockets of vulnerability to resilient EM sovereigns or broader global financial markets.
Nick, how are EM corporations navigating the macro upside?
Nick Saunders. EM corporate bonds have not been immune to the sell-off in 2022, but like the sovereign bond space, the weakness is idiosyncratic, not broad-based. Overall, the EM corporate bond index is down around 12% this year.1: The weakness was mainly driven by Russia, where corporates underperformed amid economic sanctions in response to the war in Ukraine, and China’s heavy real estate sector. Excluding Russian corporates, performance is better than US investment grade and closer to the US high yield credit market.
How should global investors consider EM corporates as part of their fixed income allocations?
Nick Saunders. The market is skewed towards investment grade bonds with an average rating of BBB, meaning EM corporates can complement developed market corporate bond allocations or EM sovereign bond exposures. We believe EM corporate bonds are an attractive asset class for retail and institutional investors looking to diversify existing bond allocations.
Where are the opportunities in EM corporations?
Nick Saunders. We see value in recession-resistant, non-cyclical sectors such as food and beverage, where companies benefit from strong brand recognition and customer loyalty. We also see structural growth potential in companies aligned with secular themes such as the energy transition, such as Indian renewables. And we are overweight domestically oriented banks operating in countries such as Mexico, Colombia and Israel with traditional lending models, strong capital positions and net interest margins. Across Latin America, we see investment potential in airport bonds.
Kay, what about EM sovereigns?
Kay Hay. As we move into a new era of financial markets where easy policies no longer work to boost all assets, we expect greater opportunities for alpha generation through active management. It may take time for value to emerge in distressed foreign EM bonds amid protracted restructuring; However, we expect the higher yields of flexible sovereigns to offer opportunities to generate positive total returns. Meanwhile, local EM bond market opportunities may open up as EM central banks near the end of their hiking cycles or even begin to consider monetary easing.
Overall, we see value in being selective, paying close attention to places where sovereign bond restructuring has the potential to move forward or where economic fundamentals are not reflected in market valuations.
Any specific areas you focus on?
Kay Hay. EM economies still have productive investment opportunities yet to be tapped, including in energy transition and digitalization, as well as traditional growth areas such as the consumption needs of a growing middle class and infrastructure development.
One important opportunity is green bonds issued by EM borrowers. About 98% of global population growth and 90% of new middle-class households will be based in EMs this decade. The increase in energy demand that will accompany this development means that the adoption of clean energy innovations across the EM world will be crucial to achieving the Paris Agreement.
In this sense, green bonds, where the proceeds are used to finance climate or environment-related projects, assets or activities, can be a useful tool for bond issuers who want to finance green investments and for bond investors who want financial results. align with sustainability goals. . In short, global investors can potentially still earn attractive returns from investing in EM bonds, taking advantage of growth potential and economic transformation.
1. Source: JP Morgan, as of December 7, 2022.
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