8.9.22 Is All the Bad News Priced into Emerging Market Debt?
Like most other fixed income markets, the emerging market debt (EMD) indexes are off to one of their worst starts to a year with the Bloomberg EM USD Aggregate index down close to 15% (through Aug 8). While interest rate policy in the U.S. has negatively impacted EMD, a series of idiosyncratic challenges have also contributed to the negative returns this year. From the Ukraine/Russian war to the Chinese property development defaults (mostly impacting corporate debt markets) and the zero COVID policy, to the more than 60 rate hikes from emerging market central banks, a lot of bad news is seemingly baked into current yield levels. As shown in the LPL Chart of the Day, all in yields are at levels last seen shortly after the global financial crises (excluding the quick spike and recovery in yields during the initial months of COVID-19). So, is the worst behind EMD investors?
The emerging market landscape is difficult to paint with a broad brush. With over 70 countries within emerging market indexes, each with their own idiosyncratic risks, the “beta” proposal is unlike other fixed income markets. With each emerging market country largely following its own monetary and fiscal impulses, we’ve see the full spectrum in policy responses to stubborn inflationary pressures. As such, at the extremes, we’ve seen a nearly 1000 basis point (10%) divergence between changes in government bonds yields so far this year (10-year yields are up 5% in Columbia but down 5% in Turkey).
That said, with global central bankers seemingly behind the inflationary curve but trying to remedy that position as fast as possible by tightening financial conditions, there will likely be sovereign market debt defaults in many of the poorer emerging economies. According to Bloomberg analysis, as much as $237 billion, or roughly 17% of emerging market sovereign debt outstanding, is at risk of non-payment in the near-term. Those under the most stress tend to be smaller countries with a shorter track record within international capital markets. Bigger developing nations, such as China, India, Mexico and Brazil, will likely weather the tightening of financial conditions but spillover risks remain. Additionally, for those sovereign entities with dollar denominated debt, a strong U.S. dollar makes repayment more expensive (although some of that risk is hedged away). Finally, there remains significant uncertainty surrounding global economic growth prospects. A hard-ish landing in more developed economies could certainly impact emerging market economies as well. “While we remain neutral on the sector, we would advocate for a cautious approach,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “And for those investors interested in lending money to emerging economies, we would advocate for an active management approach given the idiosyncratic nature of EM debt.”
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