Emerging Market Debt: hope springs eternal

Breaking the ice: markets re-open as macro improves

Resilient global growth, green shoots in China and constructive primary markets seem to point towards a tentative end to the gloomy no-man’s land where emerging markets have been frozen since the start of the Russia-Ukraine war.

The emerging market-developed market growth differential is expected to increase this year, from 2.3% in 2023 to 2.7%, as emerging market (EM) growth remains robust at 3.9%, more than triple the rate of growth in developed market (DM) economies, expected this year at 1.2% (source: AXA IM forecasts, March 2024).

China has maintained a growth target of 5% but continues to struggle with the spectre of the three Ds: debt, deflation and demographics. Policy responses have been underwhelming, but oriented towards investment, which is beneficial to other EMs via higher imports, and supportive for commodity prices, just as a booming technology sector has benefitted regional trade and growth.

Central and Eastern Europe is recovering from the shock of the Russian invasion of Ukraine. After an initial surge in inflation (CEE 4²  inflation reached 19% year-on-year at the peak in February 2023), central banks are seeing inflation targets within reach and are cutting rates: -475 bps for Hungary since the peak (to 8.25%), -125 bps for Czechia to 5.75%.

Cutting rates ahead of DM central banks signals that domestic financial conditions are slowly easing; this is positive for growth and for fiscal accounts, which have been plagued by an increase in interest costs. However, the bulk of disinflation is behind us in EM, with the exception of countries that experienced significant currency devaluations (Argentina, Turkey, Egypt, Nigeria). This makes us more cautious on EM local rates, especially given that significant rate cuts are already priced-in for this year and next.

We think that most returns in local markets are likely to come from carry, rather than a fall in yields, a stark difference to 2023, when the yield on the JPM GBI EM local currency index fell by 65bps to 6.2% at year-end (source: Bloomberg).

Hard currency debt – and sovereigns, in particular – retains the greatest potential for repricing. EM corporates have turned the corner with an upgrade/downgrade ratio that has risen from the bottom and default rates falling.

And the last shall be first: Argentina and Ecuador lead the pack on policy turnaround; Egypt gets bailed out

In 2023, Argentina and Ecuador, two of the highest yielding sovereigns in the EMBIG index, held general elections.

The starting point going to the polls was dire. In Argentina, sovereign bonds were trading in the mid to high 20s reflecting a high probability of restructuring in a country that had defaulted as recently as 2019. Javier Milei, a controversial economist with a radical reform agenda was elected in spite of a program of extreme budget austerity, in a sign the country was eager to break with a history of debt monetisation and hyperinflation.

Milei swiftly started cutting budget expenditure, engineering Argentina’s first monthly budget surplus since 2012 (in January 2024, and February 2024). The central bank started accumulating reserves after the currency was devalued by 120%.

Although the path to rebalancing the economy is still fragile (inflation reached 13.2% month-on-month in February and provincial governors are opposing tax hikes), we remain positive on Argentina as we believe current valuations are still underestimating the probability of the country avoiding (yet another) debt restructuring.

In Ecuador, market-friendly candidate Noboa was elected on a promise to put an end to gang violence that had plagued the country in recent years. His decisive action attracted support from the United States, and more positive news came in the form of VAT tax hikes, expected to boost budget revenues and help fill the financing gap in 2024. This led to a surge in bond prices with the 2035 bond for example rising to 53 as of the end of March, a 17-point increase since the beginning of 2024.

When it rains, it pours, and good news in EM continued to accumulate. Ukraine secured financial aid from the EU after Hungary’s veto was dropped; Sri Lanka came up with a new proposal for debt restructuring to bond holders; but Egypt stole the show by securing a jumbo US$150 billion investment package from the UAE, followed by several other foreign direct investment pledges from the region and, finally, an US$8bn extended credit facility programme from the International Monetary Fund (IMF).

Egypt’s case serves as an example of how EM countries can appeal to intra-regional financing when traditional international financial institutions are too slow to respond and markets are picky. A triangular configuration where the IMF, bond creditors and bilateral EM-to-EM lenders provide capital is becoming the norm across Africa, Latin America and the Middle East, with China and the Gulf Cooperation Council (GCC) being particularly active.

Sitting on the side lines: the curious case of missing flows

‘Outflows but double-digit returns’ were the key words for 2023. In all, EM-dedicated funds lost a total of US$90 billion in 2022, and US$33 billion in 2023, or a cumulative -20% of the peak assets under management in 2022³  (which exceeded US$600 billion). The first quarter of the year saw outflows again, with US$8 billion leaving EM bond funds.

With EM hard currency debt up 11% in 2023, positive year-to-date returns and an improved global growth outlook, the question is how long will investors be able to stay on the side lines?

A few swallows don’t make a summer?

Are these positive stories one-offs, and are most of the gains in EM debt behind us? We don’t think so.

The next leg of repricing could come from the completion of EM sovereign restructuring processes.

Zambia, Ghana and Sri Lanka are the EM countries currently negotiating the terms of exiting default on their sovereign obligations. Ukraine’s two-year moratorium on external debt payments is approaching its end, and it’s believed that restructuring negotiations will begin soon.

Exiting default, issuing new bonds and resuming the service of external debt will mark a turning point for these issuers, but also, in our view, for the asset class as a whole. Investors will regain visibility and start receiving carry/coupons on their holdings again. This could draw investors who are reluctant to hold defaulted/distressed securities back into the asset class and allow for a general repricing of EM risk.

We see the potential upside to the asset class coming from idiosyncratic factors, which should display low correlation to global factors.