Pandemic increases need for country-specific focus in popular EM debt sector

Emerging markets

Investor appetite for emerging markets has been on the rise, boosted by hopes of a vaccine-led recovery from the coronavirus pandemic, and by Joe Biden’s victory in the US presidential election. 

According to a recent survey from Bank of America, half of fund managers favour emerging markets more than any other asset class for 2021. The MSCI Emerging Markets Index has risen by nearly 13 per cent in November.

Emerging market debt is also growing in popularity, with EPFR data showing flows of USD3.5 billion into EM bonds during one week in November, the fourth largest weekly inflows ever.

“EMD remains a relatively popular asset class for institutional investors globally,” writes the emerging markets debt team of US asset manager Eaton Vance. 

“The irony, however, is that fund flows in the sector are still driven by index-based strategies that ignore fundamentals, even as many investors have come to recognise just how crucial individual EM country fundamentals will be in surmounting Covid-19 challenges.”

Benchmark-based approaches “may be sub-optimal”, warns Eaton Vance, adding that indexes are often highly concentrated, with ten countries accounting for 80 per cent of JP Morgan’s Government Bond Index-Emerging Markets’ index weighting. 

The asset manager, which is due to be acquired by Morgan Stanley, says: “This kind of concentration of a relative handful of larger EM issuers has been a major source of the index’s historical volatility… In contrast, outside of the GBI-EM there are 70 investable markets, with approximately USD1.1 trillion worth of local-currency market capitalisation.”

A wide spread of outcomes has been noted within emerging markets, as Asia and sub-Saharan Africa have performed well in comparison to harder-hit countries in Latin America and emerging Europe. 

The Institute of International Finance has warned that emerging markets will be hardest hit by rising global debt burdens, which is expected to reach 365 per cent of global gross domestic product by the end of the year, surging from 320 per cent at the end of 2019. Emerging markets debt has already grown by 26 percentage points this year, and EM governments are spending a higher share of revenues on repayments. 

Ecuador, Lebanon, and Argentina have defaulted, while Zambia and Angola are in negotiations with creditors.

A number of factors are at play in determining how different emerging markets countries have and will continue to fare, finds Eaton Vance, including the impact of oil prices and recession, outsized fiscal spending, debt relief agreed by G20 countries in April, low EM rates, currency values, and the process of balancing health in the pandemic with growth.

In Europe, countries including Poland, Hungary, Romania, and Czech Republic suffered from short-term pandemic disruptions to their important trade in car exports, electronics, and supply-chain parts. 

The risks of deglobalisation to these countries in the longer term are a key consideration, says Eaton Vance: “From one perspective, deglobalisation could hurt Eastern European countries if their customers push to keep their suppliers local. By the same token, Eastern European economies could benefit if companies with complex international supply chains bring production back from Asia to Europe.”

Another example is the impact of currency pegs on oil-exporting nations, which saw dollar-pegged currencies in the Gulf artificially inflate, with the UAE’s currency appreciating by 15 per cent in the first half of the year compared to Turkey’s lira. This put the UAE at a disadvantage as it competed with the country in tourism and airlines.

The need for selectivity is growing, but there is reason to be positive about the sector as a whole, finds Eaton Vance.

It points to the ability of EM central banks to lower interest rates as an “important milestone” for the sector, since during previous debt crises they were typically compelled to raise rates to defend their currencies and continue attracting capital. 

“This milestone should be seen as a broader “coming of age” phenomenon for EM debt: Investors are no longer treating the sector monolithically. There is an understanding that EM countries must cope with this crisis but did not cause it, as in prior years,” says Eaton Vance.