US dollar-denominated emerging market debt has enjoyed a strong 2017 so far, with the JPM EMBI Global Index returning about 7% in the year to date and its yield dropping towards pre-US election levels.
While these gains may dim the appeal of the asset class to some investors, especially versus local currency-denominated bonds, we believe hard-currency emerging market debt is likely to remain attractive in the near and medium term for the following reasons.
Large inflows into the asset class this year reflect an improved macroeconomic outlook across emerging markets, as rebounding – or more stable – commodity prices allow countries to repair their external and fiscal balances.
Commodity exporters took advantage of a healthy global economy and low rates to cover still-significant borrowing needs in the first quarter, frontloading their issuance plans as US President Donald Trump’s promise of fiscal stimulus led some to expect higher yields later this year.
Softer-than-expected economic data from the US coupled with Trump’s difficulties in advancing his policies, meanwhile, have now thrown that interest-rate outlook into doubt. At the same time, with the global economy still in recovery mode, major central banks should continue to dial down their stimulus measures in a very gradual manner.
While the level of emerging market debt on average is not improving, it is stabilising – for some countries, at least – thanks in large part to recovering GDP growth.
First-quarter growth data were strong almost across the board and particularly so in central and eastern European countries, which appear set to achieve growth of 3-4% this year. Even Brazil registered a rebound in the first quarter, although this might not be sustained over the rest of the year due to renewed political uncertainty.
Trade data have also improved considerably, with a bounce in exports in Asia taking place alongside improvements for commodity exporters like South Africa. Four of the so-called ‘Fragile Five’ nations – Indonesia, South Africa, Brazil and India – now have current account deficits of less than 2% (versus highs of 6-8% in 2013), leaving just Turkey, where political uncertainty continues to weigh on business and tourism sentiment.
Reduced external vulnerabilities is good news for those countries seeing less pressure on their currencies, while also making them less sensitive to a sudden stop in portfolio inflows.
More stable currencies have also helped to steady emerging market debt levels, especially in nations in sub-Saharan Africa, where high twin deficits led to a freefall in currencies over 2014-2015, triggering a ballooning of their external debt.
As the cost of servicing external debts continues to weigh on government budgets, the winners will likely be those countries that learn the lessons of the past few years, by reinforcing the fiscal efforts into which they have often been forced during crises. (In this regard, Brazil’s fresh political woes, which will probably limit the ruling coalition’s bid to pass reforms necessary for fiscal consolidation, is concerning.)
Countries like Colombia or South Africa have delivered too little in terms of fiscal consolidation, putting them at risk of further credit downgrades should growth disappoint this year or next. Ghana has also derailed from its International Monetary Fund targets and will now need an extension to finish its programme while the likes of Senegal, Cameroon or even Ivory Coast have shown better fiscal discipline, with more diversified economies and greater resilience to commodity shocks.
In addition to country-specific economic and political risk, the asset class still faces a broader threat: a shift in the global macroeconomic environment. Here we believe emerging markets would be more severely affected by the risk of a global recession than by a more aggressive tightening cycle from the US Federal Reserve, which would ultimately be a sign of stronger growth worldwide.
In short, we expect the benign macroeconomic environment, solid outlook and improving debt sustainability to support emerging market debt in the coming months. But while the first few months of 2017 were very much a play on the rally in commodity prices, the countries set to outperform over the rest of the year are likely to be those with diversified economies, with the ability to deliver strong growth while maintaining fiscal discipline.