To a large extent, emerging markets (EM) have remained untouched by banking problems that have roiled developed markets. But if U.S. inflation falls more slowly and recession comes sooner and more forcefully than was anticipated a few months ago, EMs could feel second-order effects in the form of credit repricing and greater risk aversion.
Recovery Continues, But Risks Remain
We believe the outlook remains positive for most EM sovereigns, for a number of reasons. For one, EM economic growth is expected to be at a faster pace than developed markets’ growth this year—with IMF projections suggesting an almost three percentage point growth differential between developed markets and EMs. Further, we believe the impact of banking stresses in developed markets will have a little direct effect on EM countries, as there is little direct contagion impact from the troubled U.S. regional banks to broader EM economies. In addition, following the banking stresses, there is potential for a pause in tightening from developed market central banks, which suggests inflation in developed markets could stay stickier for longer. However, while we remain constructive on the outlook for EMs, the potential for inflation to fall later than expected in developed markets raises the risk that the global interest rate environment could stay “higher for longer”.
Opportunities Across the Market
While this backdrop presents risks, it is also creating a number of opportunities—particularly on the EM sovereign and local debt side. In terms of local debt, with real rates in many EM countries now positive, we see select opportunities emerging. In fact, local markets performed well in U.S. dollar terms in the first quarter, returning 5.1%1. Investors with existing EM exposure have the potential to generate currency alpha without taking a significant market beta risk—especially in a number of Latin American and Asian countries. Brazil looks attractive from a local rates standpoint given that the economy is slowing and inflation is falling, and we also see value in Peru. In addition, concerns around China’s reopening and the impact it could have on commodity prices and exports are creating an opportunity in Asian countries, such as Korea and Malaysia. When it comes to Eastern European countries, however, the opportunity looks less compelling given that inflation in these countries remains quite high.
We are slightly more cautious from a hard currency credit perspective, given that the uncertainties around interest rates and inflation will likely keep the environment for credit volatile. However, we do see select opportunities where growth may surprise the upside. We continue to focus on countries that have diversified, competitive, and well-run economies that can withstand uncertainty and turbulence. In particular, we see value in investment grade (IG) sovereigns—where fundamentals remain strong, although growth may be slowing—such as in a number of Asian countries. We like Chile, which has largely avoided the tail risk. In the high-yield space, while spreads remain wide relative to historical averages, we see very select opportunities emerging. More specifically, some BBs look potentially attractive. We also see value in Sri Lanka, which is making a significant effort to improve its credit metrics.
In the EM corporate space, while balance sheets remain healthy overall, the picture is more nuanced. Within IG, we see value in some idiosyncratic opportunities in BBB credits, but the high-yield segment looks less attractive from a risk-reward perspective. Across the market, sectors in India and in the Gulf Cooperation Council states look interesting for corporates that are well-positioned to benefit from the economic growth, infrastructure projects, and/or green transition themes. In Latin America, corporates in Mexico continue to look attractive due to the broad impact of nearshoring. That said, we continue to believe staying up in quality makes sense—now more than ever.
Differing Banking Models
In light of the banking stresses, it’s also worth noting how EM banking models differ from those in developed markets. Most EM countries have only a handful of champion banks, the majority of which tend to be fully or partially government-owned. Governments also keep significant deposits at the banks, and other depositors tend to be widespread across the wider local economy. These EM banks tend to be more traditional commercial banks engaging in broad, conventional commercial banking activities such as residential mortgages, issuing credit cards, and making loans that are not specialized by industry. Therefore, the likelihood of seeing a deposit run on a niche bank as we observed for SVB, or a Credit Suisse-like failure, is low. Overall, the majority of EM banks are also stringently regulated and have capital levels well in excess of their Basel III requirements.
Going forward, we are relatively optimistic about the role of rates and currencies as positive drivers of performance in the EM debt space. From a credit standpoint, we remain cautious given the potential for tighter global credit conditions and higher costs of funding. We continue to emphasize close attention to credit risk through rigorous issuer and country selection, especially in an uncertain global macro environment. We believe that managers focused on those drivers are best positioned to uncover opportunities and deliver potentially superior results.
1Source: J.P. Morgan. As of March 31, 2023.
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