By Emerging Markets Team
Emerging markets, along with the rest of the global markets, have experienced significant volatility as the result of the pandemic outbreak of coronavirus, the energy market showdown between Russia and Saudi Arabia, and subsequent global demand shock. The expected benefits from last year's US-China and USMCA trade agreements were quickly superseded by coronavirus containment measures, global supply chain disruptions, US dollar funding concerns, and financial market weakness. Naturally, all of this elevated uncertainty drove consensus global growth outlook for this year sharply lower.
In a low core yield environment and uncertainty in developed markets, the recent period of volatility and price dislocations tied to the coronavirus and energy markets have revealed investment opportunities in emerging markets. We see attractive valuations in sovereign and corporate credits with strong fundamentals across the emerging markets debt opportunity set.
Central banks took swift action to introduce quantitative easing and add liquidity back into the marketplace. In March, the US Federal Reserve (Fed) delivered two initial emergency interest rates cuts: the first by 50 basis points (bps), quickly followed with a dramatic second 100 bps emergency intermeeting cut. It also announced a quantitative easing (QE) asset purchase of US$700 billion, along with numerous other programs designed to restore proper function to financial markets. Beyond the Fed, the US Congress also passed an economic fiscal stimulus of US$2.2 trillion.
The European Central Bank (ECB) has also added considerable monetary stimulus in March. After an initial stimulus of EUR€120 billion, ECB President Christine Lagarde followed soon with an emergency program PEPP (Pandemic Emergency Purchase Program) of an additional EUR€750 billon. Lagarde also mentioned that if more was needed, the ECB will increase. The program will be conducted until the end of 2020, and will see an increase in its flexibility in comparison with the existing program (PSPP, or Public Sector Purchase Program) in terms of eligible assets and collateral standard, while the proportionality of the purchases would still follow the capital of the ECB that comes from the national central banks (NCBs) of all EU member states and amounts to roughly EUR€10.825 billion.
At the end of 2019, the level of sovereign debt within emerging markets was manageable at 55%/GDP. However, to offset some of the human toll from the pandemic and economic contraction, many countries have embraced counter-cyclical fiscal policy, thus rapidly deteriorating what formerly were healthy fiscal accounts. GDP recessions and budgetary borrowing needs will likely yield worsening debt loads trends across the spectrum.
Balance of payment accounts have rapidly reset. Global trade and supply chains were severely disrupted. Business and tourism travel has halted. Remittance flows from overseas worker diaspora have declined. Meanwhile, huge changes in commodity price and volumes have benefited importers and punished exporters. Many commodity exporting countries have been forced to use international reserves and sovereign wealth funds to offset the commodity revenue declines (it should be noted that several countries specifically established these savings pools as "rainy day funds").
Most countries have debt levels that are manageable and further supported by sufficient international reserve buffers. However, a prolonged recession and commodity price decline (oil in particular) may outlast required rainy day accounts. Additionally, those without reserves that counted on issuing debt to fund their budget needs may find themselves making difficult choices between domestic and external obligations. Consequently, the post-pandemic/commodity collapse and severe global economic contraction may result in higher default rates than prior recessions. In anticipation of these risks, some emerging market countries have already requested recourse to official multilateral (IMF, EBRD, ADB) and bilateral (US, China, Japan) assistance while others may simply restructure.
A path forward
Debt markets remained frozen between early February and late March. However, primary issuance markets have recently opened up for higher-quality issuers. Nevertheless, issuance goals for the remainder of the year will be a challenging target.
Overall, we are seeing that the direct purchase of US government and US investment grade bonds by the Fed has prevented the freezing of the primary issuance market and the illiquidity in secondary markets. For emerging markets bonds, the average bid-ask spread has begun to compress and helped heal market conditions. The growing divergence in the markets between less liquid oil-sensitive credits and more liquid non-oil and investment grade debt has trughed and the elevated price volatility has declined. Credit spreads have declined in the least economically vulnerable as investors sort between likely and non-likely defaulters.
The International Monetary Fund (IMF) is making available US$1 trillion in lending capacity to help countries struggling with the economic impact of the coronavirus. Additionally, the IMF has agreed to double access to emergency financing facilities of around US$100 billion. Together with the World Bank, the IMF is calling for a standstill of debt service to official bilateral creditors for the world's poorest countries. Temporarily repurposing interest payments toward health and social expenditures may help cushion economies and will relieve an extreme liquidity stress for certain countries.
The G-20 countries have taken fiscal stimulus programs of roughly US$10 trillion, in addition to extraordinary monetary accommodation to counter the demand shock and accompanying deflationary shock. Efforts to buoy growth in developed markets will help stabilize growth outlooks for developing markets and may release investors to reinvest across many parts of the emerging markets.
Emerging markets outlook
In the near term, several factors will determine the future performance of emerging markets assets: the severity of health crisis; the success of the "whatever it takes" monetary accommodation and balance sheet expansion by major central banks; and unprecedented fiscal support by IMF, developed sovereigns and China. However, political and financial risks in weaker economies across emerging markets remain omnipresent.
Emerging markets will continue to suffer until the health crisis is resolved and investors are comforted that the economic collapse can be reversed.
We remain cautious on many segments of emerging market debt. That said, spreads have widened dramatically to price in many of the risks discussed above and if OPEC+ reduction in oil production and positive health and economic outcomes can be achieved by mid-summer, most of the market presents compelling value.
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