Outlook 2022: EM debt supply expected to wane as global economy cools; crossover support predicted

By Rebecca Melvin

New York, Dec. 31 – The emerging markets debt primary market is expected to see flat to lower issuance in 2022 following strong issuance in 2021. But totals are not forecast to be significantly lower and crossover investor support is anticipated to boost the primary, given forecasts of lower debt issuance in both U.S. investment-grade and U.S. high-yield bonds as well in 2022.

EM corporates are expected to issue $500 billion of bonds in 2022, according to BofA Securities’ Global Research. Last year, the bank prediction for 2021 was $555 billion for EM corporate issuance.

The bank predicts EM sovereigns will issue $179 billion, which is 2% lower year over year for sovereign issuers. But the forecasts for U.S. high yield and U.S. investment grade are also for lower supply next year, which is supportive of EM, the bank’s research team noted in a recent outlook report.

According to BofA, overall issuance for 2022 is predicted to reach $679 billion, which is quite a bit lower than the $828.03 billion of EM debt tallied by Prospect News for 2021 so far – effectively 2021’s total.

Lower issuance will hit other asset classes as well. “We expect strong support from crossover investors into EM debt due to a shortage of U.S. and European bonds in the corporate markets. Specifically, issuance in U.S. investment-grade corporates and U.S. high yield are expected to drop 7% and 15% to $1.3 trillion to $1.4 trillion for U.S. IG and $425 billion for U.S. high yield,” according to the report, “Peak pessimism pending,” published on Nov. 21.

Lower economic growth predicted for emerging economies in 2022 is pegged as a drag on issuance as well as the fact that peak issuance levels of the past couple of years has curbed some funding requirements. Prefunding in 2020 occurred when issuers anticipated costs related to the Covid-19 pandemic.

The obvious consequence of peak issuance is that EM debt levels are high. A recent article in the Economist referred to the asset class as “accumulating uncomfortably high levels of debt.” Since 2018, there has been a 10% increase in EM debt, leaving government obligations averaging about 63% of their combined GDP.

This will pose a challenge for debt sustainability for many countries especially amid 2022’s anticipated headwinds of lower growth rates, including China’s prospects, and higher real rates due to tighter monetary policies and lower growth rates. But the risk of meltdown, excluding the China property developers, is low, sources say.

So, while stability can be pretty much depended upon, the global growth necessary for outperformance in emerging markets is not expected to be forthcoming, BofA Securities wrote in its report. “The easy part of the recovery is mostly done and what comes next is a gradual convergence to the far from impressive pre-pandemic trend growth.”

But JPMorgan’s Global Emerging Markets Research says there will be a “happier New Year for EM once Fed repricing and the peak in EM inflation are in.”

JPMorgan recommends investors stay overweight EM sovereign and corporate credit, middle-weight EM local rates and underweight EM foreign exchange for now. “Improving EM activity data offset increasing concerns around the Covid-19 pandemic’s Omicron variant. While the variant increases uncertainty, inflation and rate normalization are more pertinent risks to growth,” according to a JPMorgan Emerging Markets Outlook and Strategy report, published Dec. 16.

BofA’s research team was not striking a strong downbeat either, but it said indicative of a shift that has occurred is the fact that a year ago, the team could find nary an EM bear and currently it can find no bulls. Nevertheless, “positioning has not been as light” as it might seem and while BofA remains conservative on EM for now, the bank conceded pockets of opportunity and the potential for improvement in the first quarter when China’s economy may bottom and global inflation peak.

A soft landing for China and a steady U.S. Federal Reserve, which are factors in the equation that have held for now, are keys to positive performance.

Fed policy shift

The U.S. Federal Reserve modified its forward guidance in December, bringing forward its dots for a median projection of three rate hikes in 2022 and announced an accelerating pace of asset purchase tapering. It abandoned its “transitory” inflation narrative and revised inflation projections up and unemployment projections down.

Specifically, after its December Federal Open Market Committee meeting, the Fed said it will double its tapering trend, thus ending asset purchases in March 2022. It noted that it is prepared to adjust this pace, however.

Markets didn’t wobble too much in the face of these revelations as they essentially “rubberstamped the hawkish shift made by Fed chair Jerome Powell two weeks earlier before the Senate Banking Committee and completes the turnaround in the Fed’s inflation narrative,” according to Luigi Speranza, chief global economist for BNP Paribas Markets 360.

While the inflation projections and the 2022 dots were on the hawkish side of expectations, the Fed’s confidence in the strength and sustainability of the recovery in spite of the Covid-19 pandemic’s Omicron variant was reassuring to markets. If the Fed is right, then the expected tightening should not materially dent the economy. But if the Omicron variant of Covid-19 proves a bigger headwind than the Fed thinks, the Fed will probably need to become more cautious, according to a Speranza update on Dec. 16.

Overall, BNP Paribas sticks with its view for a June lift-off in U.S. rate hikes, but said risks are skewed toward an earlier move. The overall implication BNP’s Speranza said is that the Fed may deliver more cumulative tightening than is priced into U.S. rates markets. This is another potentially favorable development for EM debt.

Behind the shift

Following the December FOMC meeting, Powell highlighted that the nature of the current inflation shock is different from the type of labor market-driven inflation the Fed was aiming for with the framework change. While the nature of the shock contributed to the Fed’s initial hesitance to act, Powell acknowledged that its transformation into broader based and more protracted pressures has effectively forced the Fed into repositioning itself to head off risks of entrenchment.

In addition, Powell highlighted further upside risks from tightness in the labor market. Wage dynamics are key to watch, as they have the potential to trigger a faster and potentially more disruptive policy response than that which is penciled in. Amid talk of the Fed tightening picking up, high-yield credit spreads are at their widest levels of the year.

Many predict inflation will beach in the first quarter of 2022. And easing inflation should take pressure off EM central banks to keep pace with Fed hikes, especially where tightening has been frontloaded.

The Fed hikes keep JPMorgan underweight EM foreign exchange and middle weight on rates, but overweight on EM credit. The bank said it’s too early to see the impact of this in EM economic activity data, which has recently been tracking an upturn led by Asia. But the downside risks, even if the new variant turns out to be only more infectious without being more severe, likely balance the upside from incoming recent data.

The U.S. rates curve has flattened a further 22 basis points as markets have digested a more hawkish Fed against the growth uncertainty from Omicron.

EM pressure points

One pressure point is Argentina. But the sovereign rescheduled its bonds in 2020 and will have no difficulty meeting its obligations to private creditors in 2022. Its obligations to the International Monetary Fund will require a new long-term IMF loan, however. This will help the sovereign repay large existing debts to the institution, including $18 billion due in 2022. In return, the IMF is likely to insist that Argentina raise tariffs on electricity, curtail borrowing from the central bank and maintain a realistic foreign exchange.

Perhaps the single biggest question hanging over the emerging markets economy in 2022 is China Evergrande Group and how the property developer handles the property slowdown in China.

Meanwhile, the Omicron variant is portending to be more of a wild card than initially expected. Since scientists in South Africa first flagged its presence in November, it has been detected in 77 countries and is probably present in most others, according to the World Health Organization.

The impacts were initially expected to be minimal, but since then New York has experienced its highest level of infections to date, hitting a daily record in New York state of 21,027 new Covid-19 cases on Dec. 17, surpassing the previous record of 19,942 set in January.

In response, some New York employers such as JPMorgan Chase & Co. are allowing employees to finish out the year working at home, and the Rockettes Christmas Spectacular has been shuttered.

Gleaning clues from EM equity, EPFR-tracked Emerging Markets Equity Funds experienced their heaviest retail redemptions during the second week of December since late August. But, not for the first time in recent months, strong institutional commitments to dedicated China Equity Funds helped all EM Funds record an inflow.

China Equity Funds benefited from the perception that, while many central banks are tightening policy – or about to tighten, China’s central bank is moving carefully in the other direction as it seeks to mitigate the hits to GDP growth from Evergrande’s debt crisis, as well as other factors including the costs of maintaining a zero-Covid strategy and recent regulatory crackdowns on key sectors including technology, which torpedoed markets this past autumn.

Other Asia ex-Japan Country Fund groups failed to shrug off the twin specters of rising Covid-19 caseloads and tighter US monetary policy, EPFR’s Cameron Brandt wrote in an update published Dec. 17.

In that same week, India Equity Funds recorded their biggest weekly outflow since 2020 and investors pulled more than $850 million from Korea Equity Funds. In the case of Korea, investors are responding to a variety of issues including significant domestic headwinds, Brandt wrote. Covid cases in Korea are surging while headline inflation is running at a nearly 10-year high. Meanwhile a presidential election looms in early March.

Investor appetite for exposure to smaller, higher risk, higher reward markets is also at a low ebb. Frontier Markets Equity Funds posted their fourth consecutive outflow and Africa Regional Equity Funds saw their 11th outflow in the past 14 weeks. When it comes to country allocations, Africa Regional Funds are still devoting a third of their portfolio to South Africa on average. But that is down from half of allocations as recently as early third-quarter 2020. Currently, weightings for Ghana and Zambia are at nine- and 11-month highs, respectively.

In terms of debt, EPFR-tracked Bond Funds posted their second outflow in the past three weeks in mid-December as the latest inflation and Covid-19 numbers complicated growth, employment and interest rate forecasts. Redemptions from U.S. Bond Funds hit their highest level since the final week of 2020’s first quarter, and EM Bond Funds recorded their fifth consecutive outflow while Global Bond Funds posted their third outflow in a row.

At the asset class level, both Inflation Protected and Bank Loan Funds extended their current outflow streaks during the week ending Dec.15, High Yield Bond Funds attracted modest amounts of fresh money and Municipal Bond Funds chalked up their 35th inflow since the second quarter.

Although both EM and U.S. High Yield Bond Funds are ending 2021 with a whimper rather than a bang, both have enjoyed solid inflows for 2021 overall.

“The headline flow number for Asia ex-Japan Bond Funds would be even better were it not for the toll taken by Chinese property giant Evergrande’s debt crisis,” Brandt wrote.

China Bond Funds posted their second outflow record in a row as they extended their longest redemption streak since early 2019.

EM’s 2021 debt issuance

While an occasional new issue in EM debt might pop up over the next two weeks, the tally for 2021 is essentially complete and the result is robust.

Year-to-date EM issuance stands at $828.03 billion in 1,491 deals, compared to $729.73 billion in 1,270 deals for the same period of 2020, according to Prospect News’ data.

The 13.5% spike in EM issuance compares to a similar rise in U.S. high-yield issuance for 2021. But U.S. investment-grade issuance was lower in 2021 than it was in 2020.

As usual, China was a heavyweight issuer in Asia and the world. It accounted for $279.66 billion in debt in 612 deals, representing 33.78% of total EM issuance in 2021.

Other Asian issuers also tipped the scale dramatically. On its own, Hong Kong brought $49.7 billion in 130 deals representing 6% of overall issuance. It was followed closely by Korea, which accounted for $47.13 billion of issuance in 124 deals, or a 5.69% share of total volume.

Indonesia was another issuance leader, bringing $19.62 billion in 32 deals for a 2.37% share of the tally. It was followed closely by India with $17.88 billion in 32 deals for a 2.16% share.

Away from Asia, Mexico was a sizable market participant. The country had $30.16 billion in 36 deals, or 3.64% of the total. It was followed closely by Chile with $27.68 billion in 36 deals for a 3.34% share of the total market, and Brazil was next with $25.36 billion in 34 deals and a 3.06% share.

The Gulf Cooperation Council countries were fairly active, with United Arab Emirates accounting for $23.06 billion in 30 deals and a 2.78% share of the market, followed by Saudi Arabia with $18.58 billion in 11 deals and a 2.24% share of the market.

China property developers

The headwind posed by China property developers was first identified by China Evergrande, but it is by no means limited to Evergrande alone. Others flagging warnings include Kaisa Group Holdings Ltd., Modern Land (China) Co. Ltd. and Sinic Holding (Group) Co. Ltd. Sinic failed to repay $250 million of senior notes that were due in October, and there was no grace period for the bonds. Fitch Ratings subsequently downgraded Sinic to restricted default from C.

On Dec. 17, S&P Global Ratings lowered its ratings on China Evergrande and its subsidiary Tianji Holding Ltd. to SD from CC and the ratings on Tianji bonds due 2022 and 2023 to D from C.

“We lowered the ratings on Evergrande and Tianji following our assessment that the companies have failed to honor coupons beyond the grace periods for payments. The coupons were due on Oct. 31, 2021, for $14 million in private-placement bonds issued by Evergrande, and Nov. 6 for the $83 million U.S. dollar bonds guaranteed by Tianji due in 2022 and 2023. We subsequently withdrew all our ratings on Evergrande and its subsidiaries Hengda and Tianji, at the group's request,” S&P said in a press release.

The agency noted neither the companies nor the trustee have commented on the status of the coupon payments.

“However, widespread reports in the media from reputable outlets point to nonpayment of the Tianji coupons, and we assess these reports as convincing. In addition, we believe that Evergrande has also defaulted on the coupon of the 2022 private dollar bonds because the payment was due at around the same time,” S&P said.

Hong Kong’s Shinsun Holdings (Group) Co. Ltd. is also in the crosshairs and Moody’s Investors Service has flagged the real estate development company’s weakened funding access and sizable debt maturities over the next six to 12 months.

The distress appears to be spilling over into other sectors in China, such as its steel industry.

According to a recent Reuters report, steel producers were among the best performers of the Chinese economy over the first three quarters of 2021, with China's 28 major listed mills earning more than 106 billion yuan ($16.61 billion), which was up 174% year over year and 129% higher than pre-pandemic 2019.

But the boom has ended as China construction has triggered a rare contraction in building activity. New construction starts by floor area have contracted from a year earlier since July, representing the longest stretch of declines since 2015 and the slowdown has curbed China's monthly crude steel output by more than 20% since September.

Meanwhile property sales are forecast to decline 40% in the 2021 fourth quarter and 15% to 25% in 2022.

China GDP

Given that an estimated 28% of GDP is derived from property market activity, this could curb China’s quarter on quarter seasonally adjusted annualized GDP significantly in 2022. A so-called hard landing for China’s economy is one of the two top risks for EM credit that BofA Securities’ global research team pegs in its 2022 outlook; the other is a more hawkish than expected U.S. Fed.

The global research team cited a China growth forecast revised down to 4% due to tight monetary policy and the property market slump. It predicts sequential growth will improve in the second half of 2022.

BofA’s Helen Qiao, head of Asia economics and chief China economist, thinks China’s economy will grow 4% in 2022, according to his latest forecast. That is down from 7.7% growth expected by the bank in 2021.

JPMorgan was more sanguine on China growth, raising its forecast for fourth-quarter and full-year 2022 China GDP in mid-December. The adjustment was made following November data confirming some positive trends from numbers in October, and it cited signs of easier policy. China GDP grew 4.9% in the third quarter from a year earlier, missing expectations for a 5.2% expansion.

In its Dec. 16 outlook, the JPMorgan global emerging markets research team wrote of potential growth rotation toward EM Asia.

“On a regional basis, China’s data reveal strong trade growth with EM Asia last month, but a decline in exports to all the major [developed market] countries, whereas Taiwan’s exports to [developed market] economies rose. Overall, these data are consistent with easing of supply pressures and reverse the past few months of weakening export performance for EM Asia.

“The global manufacturing PMI data also show evidence of easing bottleneck pressures, with supplier delivery times, pricing, and backlogs all improving. Overshadowing the optimism in activity data is the continued mutation and spread of Covid-19 variants – the latest being Omicron,” JPMorgan said.

Additional pressure

BofA Securities points out that Asian returns suffer most from rising 10-year U.S. real yields, despite having reasonable fundamentals and large foreign exchange reserves to stabilize their currencies.

The EMEA region appears modestly affected, while Latin America appears more dominated by idiosyncratic factors. This suggests that paying longer end rates in liquid and higher correlated Asian EM rates, such as Korea, would be an effective hedge against Fed shock to EM markets.

Last year a weak U.S. dollar, steady interest rates and the potential for further economic recovery was on tap following 2020’s epic global recession caused by the Covid-19 coronavirus pandemic. This year a strong dollar, rising rates and impending liquidity crunch will likely feature in the early part of 2022. In early 2021 EM issuance was up approximately 20% versus issuance at the same point in the year-earlier 2020 period.

The soaring number was driven primarily by Asia and specifically by China. In that timeframe, from 2004 to 2020, 2020 had the highest number of deals and largest nominal amount of issuance with $727.75 billion in 1,278 tranches.

By Feb. 12 in 2020, issuers had sold $127.71 billion of major-currency debt from 202 deals.

2021 has already posted $154.16 billion from 255 tranches, according to Prospect News’ data.

Breaking down the issuance by country a bit, China is far and away the country that has been issuing the most bonds and was running far ahead of its issuance statistics year over year.

Between Jan. 1, 2020 and Feb. 12, 2020 Chinese issuers released $25.53 billion of new paper into the market in 56 deals or tranches. In the same period of 2021, issuers in mainland China have sold $47.58 billion of debt from 106 tranches, accounting for 30.37% of the market.

Hong Kong’s numbers were up, too. Hong Kong-based issuers sold $5.61 billion of new debt in 14 transactions in the first month and a half of 2020; Hong Kong-based issuers produced 29 deals in that same period of 2021 totaling $12.23 billion.

For all of 2020, issuers out of mainland China and Hong Kong accounted for 33.91% of the market.

From Jan. 1 to Feb. 12 in 2021, issuers from China and Hong Kong have accounted for 38.18% of issuance.

The trends seem to support BofA Securities’ premise: “2022 equals 2021 in reverse.”

“One year ago, it was impossible to find EM bears; now, we can't find any bulls. However, positioning is not as light as it might seem. We remain conservative in EM for now, avoiding value traps and focusing on pockets of opportunities,” the BofA report said.

“EM might get better when China bottoms and global inflation peaks sometime in 1Q22.

“Politics remain a natural source of volatility, which adds to the risks of a less favorable global backdrop driven by higher global rates and energy prices in the coming months. A hard landing in China and a more hawkish than expected Fed remain the top risks for the asset class.”

Omicron impacts

On Nov. 26, the World Health Organization labeled Omicron a “variant of concern,” and stock markets and yields around the world fell sharply. Travel companies were hard hit. The dollar strengthened.

The new Covid-19 variant of concern initially known as the B.1.1.529 and later dubbed Omicron is the fifth with this designation, and it was behind a surge in new Covid-19 cases in South Africa to more than 2,000 cases a day from fewer than 400 cases a day between Nov. 15 and Nov. 25. Of this potentially dangerous development, the Economist wrote on Dec. 19 that if “Omicron does prove better at infecting, and reinfecting, the world, then some bumpy months could lie ahead, not least for the economy.

“Jerome Powell has suggested that if people became scared of the variant they might drop out of the labor force. That could worsen labor shortages and lead to wage growth. If it were to hit Vietnam, or even China, hard, the supply-chain crunch could worsen.”

But JPMorgan said in its outlook report on Dec. 16 that improving incoming EM activity data offset increasing concerns around the Omicron variant. While the variant increases uncertainty, inflation and rate normalization are more pertinent risks to growth. JPMorgan said that despite upside surprises in the latest inflation reports including CPI for November, incoming news support its view of a first quarter peak in EM inflation. And then easing inflation should take pressure off EM central banks to keep pace with Fed hikes, especially where tightening has been strongly frontloaded.

The Economist wrote that even though many forecasters have cut their global-growth forecasts “by a few tenths of a percentage point none of them is extending the y-axis below zero, as they had to back in March 2020.

“According to a straw poll conducted by Deutsche Bank on Nov. 29, just 10% of participants in the financial markets thought that the new variant would be the ‘biggest topic in financial markets at year-end.’ This is because the economy has evolved a level of tolerance to the disease; it no longer disrupts life as much as it used to, and so given levels of covid cases, hospital admissions and even deaths have less of an economic impact than they once did.”

“In the coming days and weeks Omicron will show its true colors. It could prove to be extremely dangerous. But in the two years since people in Wuhan started to come down with a strange new disease, much has been learned about Sars-Cov-2, how to treat it and how to live with it. That, at least, should be some comfort,” the Economist wrote.

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