Perspective

Markets

Outlook 2020: EM Corporate Credit


Edward Young

Fund Manager, Asian and EM Credit

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  • We expect EM corporate credit fundamentals to remain robust in 2020.
  • Overall EM corporate debt valuations are inexpensive, at most neutral.
  • We expect to see divergence in performance within the EM credit market amongst issuers, regions and sectors.

2019 was a good year for emerging market (EM) corporate credit, with double-digit returns in both investment grade and high yield (12.5% and 11.2% respectively, as measured by the ICE indices at 30 November 2019). The environment of monetary easing, plentiful liquidity, low inflation and interest rates, and slow yet still positive economic growth, was favourable.

Although there were numerous instances of short-term macroeconomic volatility, EM corporate credit witnessed only marginal volatility. A small number of EM countries experienced notable losses, including Argentina, but these sell-offs were well contained and did not impact the broader EM corporate credit market.

After such a strong year, is there any value left in EM corporate credit?

The outlook for 2020 is largely dependent on whether the combination of a supportive environment and stable yields remains in place. Global monetary policy is still the dominant force for returns. Central bank puts, their willingness to maintain accommodative monetary policy to support confidence and demand, while still effective, should continue to benefit EM corporate credits. But there are other drivers to consider.

The positives

Overall valuations are inexpensive, at most neutral. EM corporate debt is not as cheap as at the start of 2019, but it continues to offer pockets of value and high return opportunities. As the charts 1 and 2 below show, high yield EM corporates are particularly attractive, and EM bonds continue to offer attractive yields relative to developed market bonds.

Chart 1: CEMBI high yield vs investment grade spread differential

379266_Outlook_2020_EM_corporate_debt_V1_Chart_2_CEMBI_spread.png

Source: JP Morgan, Bloomberg ,as at 20 December 2019.

For illustrative purposes only and does not constitute to any recommendations to invest.

Chart 2: EM investment grade corporate spread vs. US investment grade corporate spread

379266_Outlook_2020_EM_corporate_debt_IGcorp_vs_CEMBIIG.jpg

Source: J.P. Morgan and Bloomberg, as at 27 December 2019

For illustrative purposes only and does not constitute to any recommendations to invest.  

The historical EM corporate default rate has surprised most market participants, falling to a low of only 1.2% in 2019. We expect this metric to remain subdued in 2020, given that fundamentals are robust for the majority of EM corporate issuers. Furthermore, EM corporate behaviour, at a time of low yields, deserves some praise as issuers are increasingly prudent.

Over the past year, companies have continued to reduce debt on their balance sheets by selling non-core assets and through liability management exercises. Companies have reduced interest servicing costs and have sought to spread out the maturities of their bond issues, so as to avoid having to repay a significant amount of debt in one go. Such a scenario could potentially force companies to raise significant capital to meet their repayment obligation.

In addition, capital expenditure growth remains modest, corporate governance standards have improved, and some companies are promoting environmental and socially friendly activities.

Compared with developed market companies in the US and Europe, EM corporate net debt is significantly lower and there have also been far fewer mergers and acquisitions, and other bondholder-unfriendly activities.

We expect EM corporate credit fundamentals to remain robust in 2020.

EM debt saw one of the largest annual inflows on record in 2019. Should current financial and market conditions continue, we expect capital will continue to flow into EM corporate credit in 2020.

The risks

Although we expect corporate fundamentals to remain stable, we think weakness at the sovereign level, through rating downgrades, political mismanagement or social unrest, could spill over to EM credit.

The fiscal accounts appear to have started to deteriorate in many EM countries, structural reforms are being delayed and there is no shortage of geopolitical risk. A few EM countries (Mexico, South Africa, India, and certain frontier markets) are already on ratings agencies “negative watch”, meaning that they could be downgraded. Should this happen, it would likely weaken EM sovereign credit spreads and probably extend to EM corporate spreads.

Tail risks have increased going into 2020 and some have the potential to escalate quickly, with significant local and global impact. The risks that we are focused on are:

  1. social unrest, not only in the weaker EM, but also in historically more stable economies such as Hong Kong SAR and Chile.
  2. potential oil supply disruption stemming from instability in the Middle East.
  3. risk of a global recession.
  4. US trade tensions increasing with China and potentially Europe
  5. 2020 US presidential election.

Disruptive technologies, tighter regulations, and environmental, social and governance (ESG) considerations, amongst other things, will increasingly change the EM corporate credit investment landscape. Some businesses might experience rapid changes, and so too could bond prices.

Selected regions and sectors will be more sensitive to any growth slowdown, commodity price changes and trade challenges. In 2020, we expect to see divergence in performance within the EM credit market amongst issuers, regions and sectors.

Where are the opportunities?

Latin America: We hold a cautious stance with the overarching concern around growth in the region. Economic growth in most Latin American economies was limited in 2019 and there is very little buffer to manage any external shocks. Recent social unrest will not help and pushing through unpalatable structural reforms is likely to be challenging. On a positive note, stable credit fundamentals and prudent corporate behaviour rank among the best in EM.

Central and Eastern Europe, Middle East and Africa: We are somewhat cautious on South Africa, Turkey, and Russian corporate bonds, which we think have further to fall. We prefer Gulf Corporation Council (GCC) corporates, now a significant component of the EM corporate credit market. We see value in a number of areas. A risk to this positive view on GCC is a sharply lower oil price and regional political tension or conflict.

Asia: We favour Asia for 2020 as the region is more politically stable and growth, although slowing like the rest of the world, is nowhere close to being negative. Market technical conditions are also among the best across the three EM regions. China remains the elephant in the room, but we expect the market to remain stable next year given targeted yet accommodative policies. Bond supply may be a concern, dominated by China issuance and the challenge remains to find diversification outside of China.

Investment grade versus high yield

With valuation in mind, we have a bias towards high yield over investment grade, particularly in Asia. As yields have come down significantly in investment grade, returns will likely come predominantly from coupon income – hence our preference for high yield. The yield on the JP Morgan EM Corporate High Yield Index in November 2019 stood at over 7% per annum in US dollar terms.

Why credit can continue to shine in 2020

Overall, we remain positive on the outlook for EM corporate credit and see it as an attractive asset class for yield, especially on a risk-adjusted basis. 2019 has been a good reminder that EM corporate credit does not require a strong economic environment to perform. The current environment – slow yet still positive growth, monetary easing, low inflation and stable to falling interest rates – will likely continue, and credit should continue to shine. Sizeable gains are unlikely in 2020 and opportunities will be increasingly selective and idiosyncratic.