End of hiking on the horizon?

The fortunes for EMs next year are largely dependent on the path of inflation, US Federal Reserve (Fed) hawkishness and the depth of the global slowdown. As risk appetite is a key driver of capital flows and thus EMD HC performance, this really matters for investors and is largely defined by the global environment. As US CPI appeared to have peaked in October, this saw a widespread rally across risk assets as optimism was revived – perhaps too much so – for a long-awaited pivot. Overly gloomy markets reversed as global risk aversion halved in November, according to our proprietary JHI Risk Aversion Index (RAI). The EMD HC asset class therefore saw the strongest monthly return since the 1990s¹ .

Surpassing peak US inflation was pivotal for markets as it signalled that the end of the US hiking cycle could be on the horizon (in our view by the middle of next year). US Treasury yields tend to hit cycle highs when the Fed pauses hiking² and so a peak in yields also comes with less risk of a strong dollar in 2023. Such strength has hampered EM performance – given economies’ exposure to dollar-denominated debt. This is because a stronger dollar has predominantly been accompanied by wider EMD HC spreads. A more constructive environment for the asset class could therefore materialise next year, as risk appetite tends to lift once the hiking is over and uncertainty subsides. The interplay between inflation and economic growth will be key to how investors perceive EM – and ergo valuations – and whether the Fed manages to orchestrate the soft landing it hopes for.

Brighter relative growth prospects for EM

As the storm clouds amass for the global slowdown in 2023, investors will likely be considering where to seek shelter. According to the IMF/WEO projections, the EM-US growth differential is set to grow in 2023 and 2024 as EM emerges as relatively unscathed in the broader global slowdown (Figure 2). Structural drivers for EM growth – such as technology and demographics – are more favourable relative to developed markets (DMs). The latter also face the more difficult retracement from years of very loose monetary and fiscal policies. In contrast, EM economies did not have the same firepower to spend while they are also generally ahead in their tightening cycles. This suggests EMs may have monetary policy buffers to draw on in a slowing global economy. The rising EM-US rate differential could be a positive tailwind for tighter EMD spreads as it makes EM relatively attractive from a fundamental perspective.

US and EM real GDP has shown negative correlation in recent decades³. This decoupling of EM from the US could spell opportunity for investors looking to diversify their portfolios. Trade within EM has expanded, and China’s growth is a significant part of this story. China could be a stabiliser for EM amid increasing signs of loosening Covid restrictions and increased support to stabilise the ailing property sector. We expect China GDP to grow 4-5% next year, aided by low base effects. According to JP Morgan October forecasts, including China boosts the EM-DM differential in year-on-year 2023 GDP growth to 2.1% from 1%⁴. However, there is a risk a deeper slowdown than anticipated – in particular in the US and Europe – could emerge. Markets are pricing in a ‘soft’ economic landing for the global economy and therefore a deeper recession (or economic ‘hard’ landing) is a risk to EMD HC spreads.

Sunshine after the deluge?

It is possible, therefore, that EM could lead global monetary policy easing as inflation subsides and so be first to stabilise or rebound in the second half of 2023. This will be positive for credit fundamentals, while in our view the growth slowdown will not be significant enough to impede credit quality. Relative growth dynamics are improving for EM which also typically leads to capital inflows.

So after a deluge of outflows in 2022, could sunshine be on the horizon as money returns to EM? With the retreat of less dedicated EM capital, a cleaner supply and demand picture has emerged. Debt issuance is expected to pick up once markets improve, but in 2023 more deeply negative net sovereign issuance (gross supply less cashflows) compared to 2022 is expected⁵. This indicates a tighter supply-demand picture that could be positive for spreads.

Carry through the storm

Ultimately, for investors it is the starting point that counts. The EMD HC asset class is priced at attractive spread levels, although it requires more granularity to fully appreciate the underlying dispersion. Distressed issuers are trading at deeply discounted valuations and so losses have already been booked in 2022 – even if the restructuring process of these distressed names lasts all of 2023. This creates a buffer against further bad news next year as the global slowdown bites.

Non-distressed high yield countries, however, are an interesting group to watch. An improving global market environment is likely to lead to regained market access to raise debt for some better-positioned economies – such as Mongolia, Kenya, Angola, Ivory Coast, Senegal, Benin and Jordan – which would reduce investment risk. Some of these countries in Africa, like Mozambique, Angola and Senegal, also benefit from strong European ambitions to diversify energy needs away from Russia and obtain a more diversified energy supply.

Disrupted supply chains have also encouraged near-shoring or friend-shoring and US-China tensions are shifting manufacturing away from China. This creates more opportunity for the EM universe, but also flags to investors the importance of diversification of trade exposure within portfolios. Opportunities abound in EM despite the storm clouds ahead. As yields have repriced higher, carry provides some cushion and should offer attractive total return prospects for next year.

IMPORTANT INFORMATION

Emerging market investments have historically been subject to significant gains and/or losses. As such, returns may be subject to volatility.

High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.

The J.P. Morgan Emerging Market Bond Index Global Diversified (EMBIGD) is a uniquely weighted USD-denominated emerging markets sovereign index. It tracks liquid, US dollar emerging market fixed and floating-rate debt instruments issued by sovereign and quasi sovereign entities.