From a fundamental standpoint, developing countries are now faced with some significant challenges, including higher borrowing costs, lower availability of foreign capital and a global economic growth slowdown
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The Franklin Templeton Fixed Income team believe 2022 was an incredibly challenging year for emerging market debt and developing countries may face some significant challenges in 2023, but there are reasons for optimism.
Market review
2022 was an incredibly challenging year for emerging market debt (EMD). Despite the rally in November, the asset class witnessed one of the worst years on record in terms of performance. The JP Morgan Emerging Market Bond Index Global Diversified declined 17.78% in 2022,1 with the longer-duration investment-grade (IG) segment recording returns of -19.76% while high-yield (HY) debt contracted by 15.68%2. The US Federal Reserve’s (Fed’s) aggressive monetary tightening primarily drove the drawdown, as resilient economic data has kept the Fed’s stance hawkish. Until recently, a strong US dollar added to rising rates to create tighter external financing conditions for emerging market (EM) issuers. Capital flows out of the assets class have exerted pressure on the sector, particularly for those countries that are reliant on foreign capital and those with weaker fiscal buffers. In this environment of higher interest rates and tighter dollar liquidity, new issuance volumes have been extremely low, exacerbating concern about EMD refinancing risks.
Market outlook
There are challenges, but fundamentals remain relatively robust
From a fundamental standpoint, developing countries are now faced with some significant challenges, including higher borrowing costs, lower availability of foreign capital and a global economic growth slowdown. The expected shallow recessions in the United States and Europe will certainly affect many emerging economies, most conspicuously through the trade channel. Adding to the uncertainty, the growth outlook for China remains difficult to predict, although the loosening of “zero-COVID” rules and a shift to a more concerted pro-growth stance should help to drive a recovery in the second half of 2023.
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To their credit, the majority of EMs have used the past period of cheap and abundant capital to extend the maturities of their external debt stock and to some degree increase fiscal buffers. Looking to the future, EM economic growth is expected to continue to outpace developed markets (DMs). While the International Monetary Fund expects DM growth to slow to 2.4% in 2022 and 1.1% in 2023, EMs are forecast to grow by 3.7%3 in consecutive years. This positive and growing gross domestic product (GDP) differential should provide additional support for the investment thesis in EMD although this is likely to gain traction once interest rate volatility subsides.
New issuance remains very low
In terms of technical market conditions, 2022 was also a record year for negative fund flows, while new debt issuance remained worryingly low, primarily among borrowers rated below IG. Access to the market has therefore become a concern, particularly for weaker countries. High-quality borrowers have been able to issue debt, especially in recent weeks, but predominantly at short maturities. Considering that most DM central banks have not reached the end of their tightening cycles and global growth is slowing, financing costs are expected to remain elevated for some time. Nevertheless, we continue to believe that those defaults that have occurred in 2022 have been due to idiosyncratic factors and are not signaling a systemic problem. With many EMs faced with heightened levels of financial stress, the role of bilateral and multilateral lenders is likely to be key going forward, as a means of providing cheaper financing and technical assistance with reforms.
Volatility will remain elevated, but there are reasons for optimism longer term
Over the near term, volatility across EMD will likely remain high, and a new cycle high in the Fed’s policy rate is likely to put further stress on the asset class. However, the 2022 selloff has provided an opportunity for active investors to uncover mispriced risk and in particular, to find securities with strong underlying fundamentals at attractive valuations. While the threat from a strong US dollar also remains, we believe that the high nominal yields in many countries can compensate taking on this additional risk. Over the longer term, we believe EM spreads should start to revert to more normal levels, albeit at a slow pace.
How to navigate EMD in 2023?
Take an active investment approach…
Over the near term, volatility is likely to remain high as both inflation and the impact that tightening has had thus far on the economy are likely to define the trajectory of US policy. These market conditions demand the ability to identify securities from issuers with favorable metrics and attractive valuations, that can weather a difficult economic environment.
…and use fundamental, bottom-up research to find value among more resilient borrowers…
Amid continued downward pressure on the sector, market turmoil should have less impact on borrowers rated IG, with stronger internal buffers. On the whole, this seems to be largely priced in at current levels, though, we believe, the higher absolute yields mean some attractive opportunities still remain. Spreads for issuers rated below IG, however, are materially higher since the start of the year. In this space, we remain focused on those issuers where we believe risk is mispriced, and where robust fundamentals should enable them to manage a period of economic weakness and loss of market access.
…as well as in select local currency markets
We also see opportunities within the local-currency universe. Many EM central banks have already reached the peak of their tightening cycles and there is potential for unwinding some of these monetary policy adjustments as global growth starts to slow and inflation decelerates. While some risk from a strong US dollar remains, particularly if US interest rate expectations should increase, the high nominal yields, and in many cases attractive real yields, across local currency debt mean that this risk is better compensated for than in the recent past.
Endnotes
- Source: JP Morgan. The JP Morgan Emerging Market Bond Index (EMBI) Global Diversified is a benchmark index that measures the bond performance of emerging countries and their respective corporate organizations. The EMBI limits the weights of emerging countries with larger debt stocks. It is done by only including specific portions of current face value amounts of debit outstanding. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
- Ibid.
- Source: International Monetary Fund World Economic Outlook, October 2022. There is no assurance that any estimate, forecast or projection will be realized.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value of investments can do down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in lower-rated bonds include higher risk of default and loss of principal. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer, or guarantor, may affect the bond’s value. Investments in foreign securities involve special risks including currency fluctuations, economic instability, and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.
Source: Navigating emerging market debt in 2023 | Franklin Templeton
