Outlook 2022: EM debt returns expected in low single digits as inflation, rates and virus weigh

By Rebecca Melvin

Concord, N.H., Dec. 31 – Returns for emerging markets debt are predicted to be in the low single digits for 2022 as the world’s bond markets remain rattled by high inflation, central banks’ monetary tightening moves and the Covid-19 Omicron variant. EM also faces stronger headwinds in terms of economic growth projections than their developed world counterparts.

The 2022 forecasts are mildly better than results for 2021, which were dragged down by the same variables starting in the second half.

Hard-currency EM sovereign debt, or debt denominated in U.S. dollars and euros, is forecast to return 1.5% for 2022, and hard currency EM corporate debt, excluding Chinese property issues, is forecast to return 3.1% for the year, according to BofA Global Research.

Among corporates, more spread tightening for EM high yield, excluding China property, is expected to foster a higher 9.1% return, compared to EM investment-grade issues, which are seen returning 1.8%, the BofA Global Research team noted in its outlook report dated Nov. 21.

The return forecast for EM local-currency debt is 3.5% for 2022.

Higher U.S. Treasury rates and spread widening are expected to zap EM sovereign debt returns by 3.5%. Without these, income from sovereign debt would have been 5%, according to JPMorgan’s Global Emerging Markets Research.

Spread widening is forecast at 10 basis points starting from end of 2021, with JPMorgan targeting a 2022 year-end Emerging Market Bond Index Global Diversified (EMBIGD) spread of 360 bps.

JPMorgan recommends investors remain overweight the EMBIGD through 2022 after turning overweight on the index midyear 2021. The overweight recommendation applies to both EM sovereign and corporate debt for 2022. Beyond that, however, the EM sovereign debt asset class is fraught with caveats, or as the JPMorgan research team puts it, “the runway looks short for this trade.”

Specifically, the research team’s EM sovereign credit 2022 outlook report, published Nov. 23, suggests moving overweight Brazil, since valuations have repriced materially, and moving middleweight in Ghana, cutting losses in the name amid heightened financing concerns. It also suggested cutting overweights in Colombia and Panama, but going long Petroleos Mexicanos SAB de CV’s notes due 2048 versus the Mexico sovereign’s 2051 notes.

In Asia, the bank recommends taking profits on long Philippines versus Malaysia and going long Power Construction Corp. of China’s 4Ľ% perpetuals, which represents one of China’s quasi-sovereign credits providing attractive yield pickup in the short end after China’s property developers’ sell-off. Notwithstanding, the China property sector’s liquidity crunch has weighed across the China corporate space, JPMorgan notes.

EM debt was seen closing out 2021 on a somewhat better note than was being sounded earlier in the fourth quarter. Returns on EM debt were negative heading into 2021’s year-end. Hard-currency EM sovereign debt returned minus 1% for the year through Dec. 16 and hard-currency EM corporates returned minus 0.9% for the same period. Meanwhile, EM local markets returned minus 10.1% for the year to date through Dec. 16, according to JPMorgan Global Emerging Markets Research.

The results contrasted sharply to the S&P 500 index’s nearly 25% gain for 2021.

Going back to the third quarter, a broad measure of market performance that tracks bonds issued in both hard currency and local currencies, the 50% JPMorgan EMBI Global Diversified/50% JPMorgan GBI-EM Global Diversified, returned minus 1.91% in the third quarter as a September sell-off reversed the quarter’s earlier gains.

Hard currency sovereigns lost 0.7% as spreads widened and Treasury yields rose. Emerging markets corporates showed resilience, notching a 0.25% gain. Local debt lost 3.1% during the quarter, driven by spot depreciation of emerging markets currencies relative to the U.S. dollar.

Local yields outpaced the rise in developed markets yields, reaching their highest level since April 2020 as several emerging markets central banks, including Brazil, Russia, Mexico and Hungary, began withdrawing stimulus and normalizing policy rates to tamp down inflation that exceeds their target ranges.

The Global X Emerging Markets Bond ETF (EMBD) sub-advised and actively managed by Mirae Asset Global Investments (USA) LLC, recorded a total return for 2021’s third quarter of minus 0.56%.

Peak inflation eyed

The entry points to EM local markets in 2022 will be indicated by a peak in EM inflation, which is predicted in the first quarter and U.S. Treasury curve pricing in the Fed cycle.

“While our view on EM local markets for much of 2021 has been underweight, 2022 is not likely to see a linear move for EM assets and should eventually present opportunities to reenter, in an environment seen as more cyclically bullish for other asset classes, according to JPMorgan’s “2022 Year Ahead Outlook,” published Dec. 16. Until now, EM local nominal rates have risen, but real rates, adjusted for inflation, have not, as the move higher in yields has just been keeping pace with the rise in EM inflation.

While the U.S. dollar stays bid in the shorter term, sovereign credit may be able to hold up better than local markets, though it will nevertheless likely produce losses. For the full year, JPMorgan forecast outperformance of local markets over sovereign credit due to the higher carry and the bank’s negative view on duration in sovereigns.

In BofA Securities’ outlook report, Peak pessimism pending, published on Nov. 21, the research team said the valuation of sovereign credit overall appears more expensive than for local markets based on the long-term relationship between spreads and ratings. That said, EM sovereign credit is still cheap relative to U.S. high-yield and is expected to attract more attention if and when the dollar peaks in 2022.

“Within sovereign credit, we look for idiosyncratic stories with high-risk premium, and our negative view on U.S. rates implies that we prefer high yield over investment grade for next year overall – though, again, we start the year initially cautious because of our concerns about short-term U.S. dollar strength,” the research team wrote.

Fed policy shift

In mid-December, Federal Reserve chairman Jerome Powell discussed the central bank’s decision not to raise interest rates yet and to move quickly to reduce asset purchases. But the Fed’s dot plots moved forward, and economists are now predicting three U.S. rate hikes in 2022.

Many see liftoff occurring in June. Fed hikes ahead keep JPMorgan underweight EM foreign exchange and middle-weight rates, but overweight EM credit into 2022. EM will stay driven by the Fed repricing, JPMorgan said. Higher U.S. rates almost always mean lower EM bonds, and JPMorgan noted that EM investor sentiment is currently low, with most debate around how damaging the Fed hiking will be, when to fade local rates, and on value in EM high-yield sovereigns.

“The main drivers they are focused on are the Fed hiking cycle and the eventual turning point lower in EM inflation, with focus also on China’s growth path, commodities pricing and naturally country-specific risks.”

In combination with Fed pressure is the threat that Omicron restrictions will put further pressure on emerging economies. Markets are now pricing in hikes across emerging markets. The 12-month priced-in policy rate change is highest for Brazil with sustained growth a necessary condition for EM assets to rally, according to BofA Securities Global Research.

“As we can learn from recent performance, the sharp increase in EM real rates didn't translate into a sharp rally in EM FX, with a few exceptions such as the ruble, despite most currencies being in undervalued territory relative to most fair value metrics. This disappointing dynamic is explained by the higher U.S. rates, a sequential slowdown in EM growth, a subsequent downward revision in EM growth expectations and increasing political uncertainty weighing on currencies.”

EM growth slowdown

In JPMorgan’s words, the expectation is “aggressive policy rate normalization in some countries triggered by high inflation prints and Fed rhetoric posing another headwind to growth.”

Schroders’ Andrew Rymer, an emerging markets investment specialist, wrote in a recent note that EM GDP growth is expected to slow to about 4.5% in 2022 from an expected 6.5% in 2021, The estimate is a dramatic negative given that EM outperformance depends on growth more than anything else.

Much is riding on China, which was a significant drag on EM in 2021. The slowing economic activity was attributed to the communist government’s crackdown on technology companies, withdrawal of Covid-19 stimulus and distress on the rise in the country’s debt-laden property development sector as real estate sales declined.

Some of the economic activity data from China for October and November delivered upside surprises, JPMorgan’s Global Emerging Markets Research team wrote. The bank noted a rise in China exports by an average 2.2% month over month and full-year trade growth of both exports and imports likely to exceed 30% for 2021.

The inputs caused JPMorgan to revise upward its fourth-quarter growth forecasts to 4.9% quarter over quarter from 4.0%. But it conceded that its full-year growth forecast remained unchanged at 7.8%.

Careful selection important

Selective market plays will be a key focus in 2022. There is some room for high-yield versus investment-grade spread compression. Latin America is lagging emerging Europe Middle East and Asia, BofA Securities noted.

“We see room for spread compression between EM high-yield and investment-grade sovereigns. Given where IG sovereigns are currently trading, HY sovereigns are trading at relatively wide levels, even when excluding large issuers that have defaulted.

“Comparing regions, Latin America sovereigns remain cheaper than EMEA sovereigns, with the underperformance that opened up in late 2020 failing to compress. This suggests that more downside risks could already be priced in for Latin America sovereigns,” the BofA Securities Global Research team wrote.

Much of the EM sovereign space is now rated high yield and the field is growing as it includes such recent fallen angels as Brazil, Turkey and Mexico. Latin America sovereign spreads have lagged behind EMEA since late 2020 and currently the region is registering 95 bps, compared to EMEA’s 105 bps.

Another angle to play is the socially responsible (SRI) or environmental, social and governance (ESG) themes that investors remain committed to. Their appetite for exchange traded funds is also undiminished: after total assets under management in ETFs hit the $10 trillion mark in November, those tracked by EPFR have taken in another $100 billion during the first two weeks of December.

As always, geopolitical risk in the form of political elections is an area to monitor. There are a number of key elections, beginning with South Korea in March and culminating with Brazil’s presidential election in October.

But JPMorgan remains overweight EM sovereigns heading into 2022 with a preference for high yield as long-term fundamental drivers suggest scope for tighter spreads. In high yield, the bank stays overweight in Egypt, Cote d’Ivoire, Mozambique, Brazil, and it moves overweight on Gabon, while staying underweight Kenya.

In investment grade, the bank remains overweight on Qatar and Romania and underweight Chile.

JPMorgan is also overweight EM corporates given strong stand-alone fundamentals and diversification and despite Omicron-related volatility and China property defaults mounting up. The bank’s preference remains for Asia and Central and Eastern Europe, Middle East and Africa. In high yield, the bank remains neutral in Latin America and underweight Middle East investment grade.

Among JPMorgan’s top long trade recommendations are India’s Adani Green Energy Ltd. 4 3/8% bonds due Sept. 8, 2024 and TMB Thanachart Bank’s 4.9% perpetual subordinated notes, a $400 million deal. A recommended short deal is Alibaba Group Holding Ltd.’s $1.5 billion of 2 1/8% notes due Feb. 3, 2031, which priced in 2021.

Entry point potential

If inflation moderates and rates remain close to central bank target levels in 2022, then the outlook for local currency EM credit could be very bright, James Barrineau, head of Global EMD Strategy at Schroders, wrote in a recent report.

Over the course of this year, the local EM Credit market yield, as measured by the GBI-EM Global Diversified index, rose to 5.65% from 4.2% as hiking cycles progressed. The spread soared to just over 430 bps, Barrineau wrote in the report published Dec. 2.

On the hard currency side, the prospects are less bright. In investment-grade, the yield spread to U.S. Treasuries is historically low, yet still offers a modest pickup to similarly rated developed debt, which has anchored stability. High yield EM bond spreads are more attractive than U.S. high yield but lack the stable operating environment. Being active and taking a selective approach is key. Some lower rated credits will struggle with funding requirements and the need for fiscal tightening (many sub-Saharan and frontier countries). Others might not be default candidates but will struggle with the politics of regaining debt sustainability as both growth and spending slows.

The most highly credible central banks, such as Russia and Mexico, will likely be the first to tap the brakes on hikes. Others in central Europe and Brazil will take months more to corral inflation trends. Asian countries are closer to developed market credibility than other EM regions and while local yields are lower, currency volatility is also much more subdued.

“Over the course of 2022 we expect virtually the entire asset class to have completed hiking cycles and be left with real interest rates well above developed counterparts, perhaps with rate cutting cycles coming into view,” Barrineau wrote.

Fading fund flows

2022 inflows are a concern following a year of poor performance and Fed tightening ahead. Looking at the state of fund flows closing out 2021 – including equity ones to glean market insights – South Africa Equity Funds posted their fifth outflow in the past six weeks in the second week of December, while flows into South Africa Bond Funds climbed to a 10-week high, according to data tracker EPFR.

Korea Equity and Bond Funds both recorded their biggest weekly outflows since early June and redemptions from Brazil Equity Funds were the biggest in nearly six months. Cryptocurrency Funds absorbed fresh money for the 17th straight week, Mortgaged-Backed Bond Funds chalked up their largest outflow since the second week of 2020’s second quarter and Total Return Funds extended their longest redemption streak in more than 17 months, according to an EPFR update published Dec. 17.

The jury is still out on the impact of rising Covid caseloads triggered by the Omicron variant, but the latest round of inflation numbers delivered a verdict of “not transitory” that major central banks are expected to heed. The Bank of England was the first to respond, raising its key rate, and reinforcing the perception that the US Federal Reserve will accelerate its timetable to wrapping up its current quantitative easing program, EPFR’s Cameron Brandt wrote.

JPMorgan notes that outflow pressures continue across EM bond funds, but there are inflow pockets starting to occur. Inflows for EM bonds in 2021 for EM dedicated funds through Dec. 16 stood at $53.6 billion. JPMorgan forecasts $30 billion to $40 billion of EM-dedicated bond fund inflows in 2022, versus a forecast of $65 billion to $75 billion for 2021.

Looking ahead

EM debt has been hampered not only by central bank tightening but also by fears of China intervention, the shaky China property developers’ sector and reignited Covid-19 fears.

China’s checks on internet-related companies rattled markets in the third quarter. Following an investigation of Alibaba Group Holding that resulted in a $2.8 billion fine last April, the government followed up with investigations of other internet platform companies as well as online insurance, education, video gaming companies and casinos. Subsequently the government called wealth redistribution by the name of "common prosperity,” spurring private companies to make large contributions to social causes. How far government actions will reach is an unknown that has spurred market fears.

Northwestern Mutual Wealth Management Co.’s investment professionals reallocated capital from inflation- and rate-sensitive emerging markets toward international developed stocks in June.

Meanwhile, debt laden property developers faced slumping sales in 2021 and that uncertainty gave way to emerging markets assets lacking momentum in either direction for most of the third quarter.

After China Evergrande Group fell into default in the autumn, its bond prices fell to record lows, and investors were purchasing some bonds at 20. The company has $20 billion of international bonds outstanding and such investors as Apollo Group Management Inc. are buyers of these bonds now in hopes of better recoveries despite the likelihood of complex restructuring ahead.

The Evergrande 5% bond, one of the most frequently traded bonds, sank to as low as 18.5 recently before retracing to 20, according to MarketAxcess. It traded around 30 in September and around 70 in the middle of June.

If talks fail, Evergrande’s dollar-denominated bonds are governed by New York law and were issued by an entity incorporated in the Cayman Islands, supposedly giving creditors access to both legal jurisdictions for asserting their contractual rights. But whether China will heed the authority of those jurisdictions is a question mark.

In 2021, fears of more persistent inflationary pressures at the beginning of the year gave way to the spread of the Delta variant of Covid-19 and supply chain disruptions by midsummer when expectations were that inflation was still transitory.

That parlance gave way to the view of more persistent inflation and an early unwind of the Fed’s $120 billion per month bond purchase program.

Experts can make educated predictions about what will happen next, but there will definitely be surprises along the way. Unexpected strength for the economies of the emerging world would be a welcome surprise. Perhaps this one could materialize on the back of stronger oil. If it does occur, a restart of the EM debt rally would be only one of the many positive results.

© 2015 Prospect News.
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