Outlook 2023, Emerging markets debt: a new dawn?

Emerging markets (EM) have recently faced an extremely challenging environment characterised by slowing global growth, geopolitical disruptions, persistent inflationary pressures and a severe tightening in global financial liquidity conditions.

Such a global backdrop warranted a cautious stance towards EM assets over the course of 2022. But, after recent market falls, we now believe that attractive investment opportunities are appearing.

All types of EM debt funds have been through a period of unprecedented outflows. This has coincided with a large re-pricing in a number of EM fixed income assets at a time when monetary tightening cycles in most EM countries have become well-advanced. We now believe that the EM debt asset class has discounted the recent global dislocations to a large extent.

The tumultuous global backdrop of recent years has also eclipsed the reasonably strong macroeconomic fundamentals we see in selected emerging economies.

While we are still of the view that inflation is likely to remain entrenched given the continued gigantic global money supply overhang accumulated during the pandemic, we expect some temporary respite in global inflationary pressures in 2023. This respite is likely to result from the recent weakness in global demand, more favourable CPI base effects, the recent correction in energy prices and the substantial easing in global supply chain dislocations.

The impact of the Federal Reserve’s monetary tightening on the US economy is also now starting to bite. Commercial bank lending growth appears to have peaked in the US and the global credit impulse is starting to roll over after its post-pandemic surge.

Our inflation model shows that an increasing number of countries are already experiencing a noticeable deceleration in inflation and this is likely to be rewarded by the markets, particularly in EM countries where real rates are high and where central bank tightening is already in its very late stages. Figure 1 shows the latest signals from our inflation model.

Despite some deterioration in sovereign credit metrics during the Covid pandemic and recurrent flare-ups in political tensions, a number of EM countries such as Mexico, Brazil, Indonesia and South Africa still exhibit relatively robust macro-economic fundamentals. This is thanks to strong balance of payments, manageable financing needs, cheap real effective exchange rates and credible monetary policy frameworks.

The asset class should also be supported by the prospects of growth resurgence in China following the expected post-Covid full re-opening of its economy in 2023. These improving prospects can be seen in growth expectations differentials becoming convincingly in favour of EM vs developed markets (DM) for the first time in three years, as shown in figure 2 below.

This relative improvement in EM growth prospects has not yet been reflected in the valuations of EM assets, which remain at historically depressed levels in most EM debt sub-sectors. This is particularly the case for EM dollar debt high yield, which still trades close to valuation levels only seen during past systemic crises, as illustrated by figure 3 below.

Given the high levels of yields in nominal and real terms, investors could be handsomely rewarded in 2023 by maintaining exposures to selected EM local and hard currency bonds in countries where the policy frameworks are credible and where macroeconomic fundamentals are reasonably solid.

In this regard, we favour local currency bonds in Mexico, Brazil, Indonesia, South Africa and a number of dollar debt frontier markets such as Angola and Ivory Coast. We also see some value in Central European bond and currency markets but a convincing peak in inflation in Eastern Europe is required for us to turn unequivocally bullish in 2023 on this region.