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As major equity and fixed income markets reel from ongoing volatility and gloomy economic news, Newton portfolio manager Carl Shepherd, Insight head of fixed income Colm McDonagh and Mellon senior portfolio manager Josephine Shea consider how emerging markets are faring and what fixed income potential they might hold.

According to Institute of International Finance (IIF) figures, investors pulled a record-breaking US$83 bn out of emerging market debt and equities from 21 January to 23 March.¹ Daily tracking of non- resident portfolio flows by the IIF suggests the first quarter of 2020 saw the largest ever EM outflows, exceeding even the worst points of the global financial crisis.²

While China, the original source of the pandemic, appears to be over the worst of the crisis and is expected to grow by 2.1% this year, all other emerging markets look set to slip into recession. The IFF predicts India will contract by 0.3% in 2020/21 (01 April to 31 March), with economic activity in Brazil expected to slow by 4.1%, with a GDP decline of 5.8% in Mexico.

In emerging Europe, IIF analysis suggests the Turkish economy could shrink by 2.7% while Russia could see its economy contract by 5.1%. Wider IMF forecasts suggest emerging markets will see negative growth of -1% in 2020, though it does not rule out a possible rebound to +6.6% in 2021.

Against the current backdrop, a collapse in exports, dwindling remittances, tightening credit conditions and the relative strength of the US Dollar have all helped contribute to falling EM asset prices. Worryingly, the sovereign debt picture in many emerging markets looks increasingly gloomy with defaults expected to mount this year.³

Some help is at hand, however. In April the IMF announced a US$1trn loan facility for countries impacted by Covid-19⁴ and the World Bank is planning to provide up to US$160bn of support to developing countries over the next 15 months.⁵ Some emerging market analysts also hope major market interventions by central banks such as the US Federal Reserve will have a trickle-down effect which will eventually help buoy emerging markets.

Commenting on the current market outlook and wider picture for the emerging market fixed income sector, Newton portfolio manager Carl Shepherd says: “As yet we still don’t know what form the recovery will take in developed markets or how long it will take for confidence to return. However, what we have seen is major government intervention in markets to support the global financial system.

We believe that at some point the money developed market governments such as the US have injected into economies will find its way into emerging markets. From a fixed income standpoint we are seeing some record low yields in EM debt and that isn’t going to go away any time soon. The hope is that government money will eventually find its way into assets such as EM bonds as the search for yield begins again. A lot depends on how quickly the crisis ends.

Insight head of fixed income Colm McDonagh also believes the quality and speed of policy response to the crisis and how quickly companies can get back to work will be critical factors in regional emerging markets recovery. Despite the many challenges facing EMs and investors in their sovereign and corporate debt markets, he remains optimistic recovery will come over time and could deliver positive new investment opportunities.

While there is currently a significant amount of dislocation and dispersion across markets and we believe sovereign EM defaults could be higher than corporate defaults in the months ahead, market disruption could ultimately create some new opportunities for security distinction and selection in EM debt in the coming 12-18 months.

Commenting on some recent positive indictors after a torrid first quarter, Shepherd adds: “The market is clearly still not fully back to normal. The bid/offer spreads on some higher risk bonds are still quite wide. However, liquidity in the cash market does seems to have improved and we are not seeing the type of massive LIBOR spikes which would show there is a real dearth of liquidity.

Strength test

Whatever happens in emerging markets in the months ahead, those which are financially strongest look set to show more resilience than weaker, less economically robust EMs.

Mellon senior portfolio manager Josephine Shea also expects the number of EM sovereign debt defaults to rise this year, though she adds EM corporate debt does appear more resilient.

Commenting on the relative strength of emerging markets, she adds: “Countries that may prove stronger in the current economic conditions are those with investment grade status and which have robust financial buffers, good ESG levels, strong governance and more developed healthcare systems.

In contrast, ‘single B’ rated countries have often been commodity driven exporters with weak governance and political systems and very little by way of financial buffers. We believe those types of countries will see a prolonged delay in recovery. Some of these countries are also heavily dependent on remittances and tourism, hard hit by the Covid-19 pandemic.

A global oil price slump has further complicated the picture for some EM markets. On April 20 the Brent oil price dipped below US$20 for the first time in two decades and ongoing volatility remains a major concern from some EM markets dependent, to varying degrees, on oil remittances. Shepherd points to Angola and Gabon as typical of a cluster of oil-producing African nations highly vulnerable to price fluctuations.

Against this backdrop, Shea says one of the biggest fears is a second wave of coronavirus across more developed markets. This, she posits, could effectively kill off early signs of global economic recovery, reverberate across emerging markets and could be particularly damaging for those EMs dependent on oil exports.

Nevertheless, despite these potential pitfalls, she does see at least some positive signs ahead and remains optimistic for the longer term future of fixed income emerging market investment.

As developed markets eventually start to operate again, so the demand for global products should start to come back and emerging market assets should start to show some signs of recovery. That said, we believe high yield emerging market debt – hard hit in the crisis – may take longer than investment grade assets to recover.

Despite all of this we also believe there is still a strong rationale to invest in emerging markets. In the longer term – and when you look at the negative interest rates in western developed markets where pension funds and insurance companies still have considerable liabilities they need to match – some emerging market assets do appear to offer potentially attractive long term returns. How quickly markets can recover remains uncertain but we believe investors will return to these markets over time,” she concludes.

¹The Economist. The coronavirus could devastate poor countries. 26 March 2020. ²IIF. Capital Flows Report. Sudden stop in emerging markets. 09 April 2020.
³Wall Street Journal. Coronavirus heightens risk of emerging market defaults. 29 March 2020.
IMF. The IMF’s response to Covid-19. 17 April 2020.
World Bank. World Bank Group launches first operations for Covid-19 (coronavirus) emergency health support, strengthening developing country responses, 02 April 2020.

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