Has EM Debt Reached a Turning Point?

Emerging markets (EM) debt was hit hard during the pandemic, and many countries continue to face challenges as they deal with new waves of COVID-19. The asset class is also facing potential headwinds from rising rates in developed markets, namely the increase in the 10-year U.S. Treasury yield. As a result, sovereign, corporate and local debt have underperformed so far this year, returning -4.5%, -0.8% and -6.7%, respectively, in the first quarter.¹  Of note, however, performance across the asset class has been notably strong since the steep, pandemic-induced decline a year ago—with sovereign, corporate and local debt all returning more than 10% from March 2020 through March 2021.
 

FIGURE 1: EM DEBT YEAR-TO-DATE PERFORMANCE

Source: J.P. Morgan. As of March 31, 2021.
 

Sovereign & Local Debt: A Positive Growth Story

Rising interest rates clearly pose a headwind to emerging markets—particularly for sovereign debt, which is longer in duration—and historically, rising rates have led to foreign outflows, and therefore less financing, for EMs. However, there are reasons to believe this time may be different. For one, the financing needs of EM countries have come down significantly in the last several years. Specifically, many EMs that were running fairly sizeable current account deficits have been able to gradually improve their current account balances, in some cases even turning them into surpluses. With EMs less dependent on financing from foreign investors, potential outflows in a rising rate environment could be less of a challenge. At the same time, the overall EM growth story remains supported, in our view. In addition to the improving economic backdrop in the U.S. and parts of Europe—which will certainly help drive demand for EM goods and services in the months ahead—China, a big source of commodity demand for EM countries, has experienced solid growth in the aftermath of the pandemic. Commodity prices, too, have increased, which should provide further support.

Moreover, there is no shortage of supply when it comes to capital support. The moratorium and forbearance measures that provided much-needed support last year remain in effect and continue to benefit EMs, giving countries and companies more time to work through ongoing challenges. Multilateral institutions have also embarked upon debt relief efforts. For instance, the IMF recently announced a plan to issue $650 billion of new special drawing rights (SDRs), which are essentially reserve assets, similar to foreign currency reserves held by central banks. EMs are expected to receive roughly $90 billion of this, although the IMF is currently involved in discussions around how the funds should be allocated. This significant relief effort is largely being ignored by the market, even though for some countries it could mean the difference between defaulting or not defaulting on debt. 

This combination of factors, in our view, suggests the forces may be in motion for EM economic growth to surprise to the upside this year—which would provide strong support to EM asset classes. Currencies, for instance, could experience a strong rebound after lagging the broader EM debt universe in terms of their post-pandemic recovery. In fact, we believe currencies now offer significant upside potential, particularly against the backdrop of countries’ lower financing needs and continued demand for commodities from both China and developed markets. 

From a hard currency perspective, we are optimistic about countries like Brazil, which we rate internally as investment grade. Despite facing continued challenges from the virus, job growth in Brazil has consistently beat expectations for the last several months, suggesting that economic activity is improving. At the same time, we see value in high yield countries, where spreads have generally remained wider post-pandemic than in the investment grade space. That said, we are more discriminating when it comes to high yield given the diversity of the space—seeking to avoid countries where financing measures are deteriorating, and taking positions only in countries where we have formed high conviction, including Ukraine, Serbia and Oman.
 

Corporate Debt: Strong Recovery Amid Rising Rates

We also continue to see opportunities in EM corporate debt. Broadly speaking, hard currency corporate debt has been less impacted by rising rates than sovereign and local debt. This is largely due to the asset class’ shorter duration—whereas sovereign debt has a duration of roughly eight years, hard currency corporate debt has a duration of roughly four. As a result, EM corporates have historically shown resilience to rising U.S. Treasury yields, with credit spreads tightening during periods of rising developed markets rates in eight out of the last 10 years.² It is also worth mentioning that, like in the sovereign space, higher developed market rates do not necessarily equate to a higher probability of default. In the corporate landscape, the CCC segment of the market is quite small, meaning few companies are at risk of being closed off from the market as a result of higher rates or a higher cost of funding. And most issuers—including lower-rated CCC issuers—have been able to access the market and refinance their debt. 

Looking at the market today, spreads in many cases are close, or already back, to pre-pandemic levels. In terms of the recovery, commodities have led the charge on the back of higher oil prices, which combined with strong demand from China, could lead to double-digit growth in revenues and EBITDA for some issuers this year. The real estate and transport sectors, on the other hand, have lagged, and likely face a longer road to recovery. Against this backdrop, the high yield segment of the market looks particularly attractive, as spreads have remained wide relative to investment grade-rated EM corporates. While this has normalized somewhat in the last six months, the spread differential remains wide relative to history, suggesting there is still value in high yield corporates—particularly given the asset class’ shorter duration profile (Figure 2). 

We are also monitoring the consequences of risk flare-ups in certain EMs, such as Turkey and Brazil, over the last few months. While these situations can represent risks, we have also continued to find value opportunities in EM issuers, often globally diversified companies, that have been unfairly punished by markets because of the country in which they’re domiciled. 

FIGURE 2: SPREAD DIFFERENTIAL BETWEEN EM IG AND EM HY

Source: J.P. Morgan. As of March 31, 2021.
 

What’s Next?

The environment we are in today appears to be very supportive of emerging markets debt as a whole. While there are ongoing risks facing the asset class, there are also reasons to believe that growth will be positive in the months ahead—potentially paving the way for strong performance across sovereign, corporate and local debt. That said, not all sovereign and corporate issuers can be painted with the same broad brush given the diversity, and dispersion in performance, across the space. In this environment, credit and country selection matters. And in our view, active managers that do their homework and closely assess risk on a country-by-country and company-by-company basis are best positioned to identify the countries and credits that stand to benefit the most through the post-pandemic recovery.
 

1. Source: J.P. Morgan. As of March 31, 2021.
2. Source: J.P. Morgan. As of March 24, 2021.