Emerging Market Debt: Finding Opportunities in the Cracks
Author: Tristan Sones
May 15, 2020
The COVID-19 crisis has highlighted a truism about emerging markets (EM) that experienced global investors have long recognized: they are not homogeneous. In fact, trends in globalization, technology and politics had been exposing fault lines in the EM world long before the coronavirus pandemic. Yet it’s fair to say that the global health crisis has accentuated those tectonic shifts, and the impact goes beyond equities; it is also at play in the much larger EM debt market.
In general, emerging market bonds represent an area of significant potential growth in the long term, and the hit they have taken during the pandemic has made valuations more attractive. But the COVID-19 environment has complicated the landscape for fixed income and is presenting new risks as well. Understanding where the fault lines lie between different EMs will be critical to discerning winners from losers.
The clearest divergence lies in the varying ways EM governments have responded to the crisis. Some Asian countries – most notably China, but also South Korea and Taiwan – were quick to implement containment protocols as well as fiscal and monetary stimulus, and their economies are poised to recover before those that were slower to respond (for example, Turkey and Indonesia). Elsewhere in the world, the responses have also diverged. Some – such as Poland, Chile, Brazil and Peru – have responded with stimulus measures that range from 6% to 12% of GDP, according to Statista, a global research website. Others, however, lack the fiscal capacity for such outsized responses. Argentina recently expanded its stimulus measures, but to only 3.5% of GDP; Turkey’s initial fiscal response, meanwhile, comprised 1.5% of GDP, says Statista, which looks meagre by global standards.
It not likely a coincidence that some countries with minimal coronavirus responses also carry high levels of U.S. dollar-denominated debt – another major fault line dividing emerging markets. While the mid-March spike in demand for U.S. dollars has mitigated to some extent, the greenback remains strong, which has caused massive currency devaluations for countries where dollar debt runs high, such as Turkey and Argentina. As a result, yield spreads between U.S. Treasuries and dollar-denominated EM debt are now about double what they were before the crisis. That represents a significant constraint on those countries’ ability to respond to COVID-19, as well as on their post-crisis potential.
Other EMs that rely more heavily on domestic debt are less exposed to FX fluctuations, and the growth hit from COVID-19 has presented an opportunity for their central banks to lower rates, which supports bond prices. Taiwan and Korea, for example, have seen their currencies remain largely stable against the U.S. dollar. Overall, the divergence in bond performance is stark: traditionally high-yield EM bond prices are down about 18% year-to-date, while investment-grade ones are only down roughly 3%, according to Bloomberg data.
From a fixed income perspective, China merits special focus. The market for its bonds has been remarkably robust. That’s not only because it is relatively well-insulated from foreign exchange volatility, but also because China is poised to lead the global pack in recovering from the crisis. Its industrial capacity is already coming back online, and we expect export demand from developed countries – probably first in Europe – to rise in the second half. As well, China’s economy is much more domestic-focused and far less reliant on exports than it was even a few years ago, and we think it’s likely that Beijing will implement further stimulus this year to spark domestic demand.
Granted, full-year GDP growth in China will probably be a fraction of what it was in 2019, but at least it will be growth. Countries such as Singapore and Malaysia, which are more exposed to the global value chain, are looking at sharply negative growth in 2020. On the other hand, a swift recovery for China could be the best hope for recovery in many EMs, not just in the immediate Asian satellite area, but around the world.
That’s in large part because of China’s outsized role in commodity prices. As a group, emerging markets are less reliant on commodity production than they used to be, but revenue from commodities remains critical for many EM economies. China, of course, is the world’s largest consumer, so commodity exporters like Brazil, Argentina and Indonesia could ride its economic coattails in the post-COVID-19 environment. Even among oil exporters – which have been hit by the double-whammy of coronavirus and the petroleum rout – this knock-on China effect could present significant upside. Notably, China’s demand for crude has already begun to rebound. In the meantime, net oil importers, such as India and Turkey, are benefiting from historically low prices.
One wildcard for emerging markets is the extent to which they will be able to tap into multilateral financial support to bridge them through the crisis. The International Monetary Fund has noted more than 90 countries have applied for its assistance, and the prospect of an IMF backstop might make certain EM bonds even more attractive.
It’s important to remember that nothing lasts forever – not even (hopefully) a global pandemic. And emerging markets as a group still boast the secular advantages they long have: favourable demographics, high growth potential and improving socio-political environments. However, fixed income investors need to be picky. Valuations look attractive, but country allocation – taking into account points of divergence that the current crisis has only widened – will be key to navigating a radically altered landscape in the post-COVID-19 world.
Tristan Sones is Vice-President and Portfolio Manager, Co-Head of Fixed Income at AGF Investments Inc. He is a regular contributor to AGF Perspectives.
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