From Rates, to Growth, to China: What’s Next for EM Debt?
For emerging markets (EM), uncertainty escalated in the third quarter as the Delta variant spread across the world and the regulatory crackdowns in China increased market volatility. Accordingly, performance was mixed for the quarter, with corporate, sovereign and local debt returning 0.25%, -0.70% and -3.10%, respectively.1 On the positive side, however, the asset class continues to benefit from a recovering global economy, as well as progress in vaccination campaigns across many EM countries.
Sovereign & Local Debt: A Supportive Backdrop Despite Headwinds
While the events in China, along with expectations for rate increases in developed markets, have impacted emerging markets, there are reasons to believe the long-term picture for the asset class remains encouraging. For one, many EM countries have lowered their financing needs over the last couple of years, and trade balances across the region have significantly improved since the onset of the pandemic—aided by higher commodity prices and consistent demand. As a result, while rising developed market rates can impact EM countries’ ability to access external financing, many countries today are less reliant on financing from foreign investors, and thus better positioned to withstand outflows.
FIGURE 1: EM TRADE BALANCES IMPROVE SHARPLY
Source: Bloomberg. As of July 31, 2021.
At the same time, we believe the overall EM growth story remains positive, underpinned by the ongoing recovery across both developed and emerging markets. In particular, the increased fiscal firepower in developed markets has sustained demand for EM goods and services. Meanwhile, capital support from post-pandemic moratorium and forbearance measures remains in place, and continues to benefit EM countries. Global trade has also started to re-engage after remaining largely flat for a number of years, which should continue to support the asset class.
Near-team challenges exist, to be sure, but we believe these factors provide a broadly supportive backdrop for EM sovereign hard currency and local debt. On the sovereign hard currency side, we continue to see opportunities across both investment grade and high yield countries. BB-rated issuers like Colombia, Morocco and Serbia look particularly attractive, in our view, as spreads in many cases have remained wider in the post-pandemic environment relative to investment grade. However, given the diversity, complexity and significant dispersion in performance from issuer to issuer, active management—coupled with a bottom-up approach to country selection—is key to capitalizing on opportunities and avoiding the ‘bad apples’ that exist in the space at any given time. Local debt will likely be more of a mixed picture, with currencies almost certain to face headwinds in a rising rate environment, particularly those countries that remain more dependent on foreign financing. While local rates will be impacted as well, countries that have been able to gradually improve their account balances—such as South Africa, Brazil and Mexico—look better positioned.
Corporate Debt: From Volatility to Opportunity
The Chinese Communist Party’s regulatory crackdowns roiled the EM corporate debt market in the third quarter—specifically the new regulations and fines imposed on sectors like real estate, tech and education. Concerns around Chinese developer Evergrande, and the potential contagion to other issuers in the real estate sector, added further instability in the market.
To the extent that the ongoing regulations—and waning activity in the real estate sector in particular—lead to slower growth out of China, there could be spillover into the rest of the EM universe, although the effects are unlikely to be uniform. For instance, metals & mining companies could be adversely affected given that China accounts for roughly 50–75% of global metals demand. In contrast, the energy sector should remain well-supported given that it is not as directly dependent on China, which accounts for roughly 10–12% of global consumption (Figure 2).
FIGURE 2: CHINA SHARE OF GLOBAL DEMAND FOR SELECT COMMODITIES
Source: J.P. Morgan estimates. As of September 2021.
Looking ahead, while EM corporates will continue to benefit from a recovering global economy, conditions may become more challenging as supply-chain disruptions exacerbate inflationary pressures and potentially weigh on profit margins. The current power cuts in China, which are an attempt to meet official energy use targets, could create further shortages of goods, amplifying these challenges. On the positive side, EM corporates as a whole remain quite strong from a fundamental perspective. Revenue and EBITDA are back to pre-pandemic levels for a number of issuers, and we expect to see further improvement as the global economy continues to recover. Outside of China’s beleaguered real estate sector, leverage across the board is also fairly healthy, and in many cases back to pre-pandemic levels. While EM corporate default rates may rise going forward, we believe defaults will be largely concentrated in Asia.
Against this backdrop, we believe EM corporate debt continues to look attractive, particularly as spreads remain wide relative to developed markets. For example, EM investment grade corporates are currently offering a premium of roughly 20–30 basis points (bps) over their developed market peers, while high yield is offering a roughly 50–70 bps pickup.2 We also continue to find opportunities in globally diversified EM companies that have been unfairly punished by markets due to idiosyncratic risks in the countries where they are domiciled. Often, these risks cause corporate spreads to widen beyond what fundamentals would suggest, creating opportunities to identify solid issuers at attractive prices—such as we have seen recently in China, India and Turkey. In the current environment, there may also be advantages to considering EM short-duration debt, which can provide an opportunity to pick up incremental yield and diversification, with less volatility.
There are a number of uncertainties on the horizon—from developed market rate hikes, to China’s political and regulatory landscape, to geopolitical tensions. While these factors, and any number of others, could create volatility in the near term, we expect there will also be opportunities to identify and capitalize on inefficiencies in the market. However, bottom-up, fundamental analysis will be paramount, not only in uncovering countries and companies that should prove defensive in times of market turmoil, but also in avoiding weaker issuers and navigating risks.
1. Source: J.P. Morgan. As of September 30, 2021.
2. Source. J.P. Morgan. As of September 30, 2021.