We certainly are in an unprecedented time today, and all assets—including emerging market debt—have experienced heightened volatility in the first quarter of the year. We started to see an avoidance of risk as issues in the oil market started to surface—including a breakdown in the OPEC+1 agreement to limit production—and with the emergence of COVID-19 in China which reduced demand for nearly all commodities.
As COVID-19 started to spread beyond Asia, many investors began to sell all assets perceived as risky, including emerging market debt. While emerging market economies have dramatically changed over the past couple of decades, many of the larger borrowers are still sensitive to commodity prices—oil in particular.
Government-enforced shutdowns significantly reduced economic activity, including tourism and trade, which are vital to many emerging markets. Countries have effectively been put into a coma in an attempt to stave off the worst of the global pandemic.
In April, the decline in oil prices accelerated—even turning negative in one futures contract—an unprecedented event. The market was faced with a situation where storing oil was actually more expensive than the product was worth, leaving traders with a very specific, technical issue.
That said, while the coronavirus has sharply curtailed the demand for oil, the longer-term outlook remains encouraging. Within emerging markets, some oil production is in the hands of sovereign governments, who can plug short-term gaps with supplementary budgets. So, those producers should have a reasonable amount of flexibility, in addition to benefiting from low lifting costs.
In terms of performance across emerging market debt, hard currency sovereign credits have been worst affected, followed by local currency sovereigns which have done marginally better—although here the position is mixed. While some of the local assets themselves performed quite well, local currencies have been negatively impacted versus the US dollar.
Emerging market corporate debt has performed relatively well during this crisis period in the sense that corporates provide a large exposure to some of the better-performing parts of the world—namely Asia. That may seem a bit counterintuitive considering the economic fallout we are facing today stemmed from the virus outbreak in China, but China actually has a strong risk profile and good credit ratings.
Investors still hold onto the misconception that emerging market corporate debt is more risky than sovereign debt, but that’s not always the case.
In terms of year-to-date performance of the various credit buckets, the higher quality ones have seen single-digit declines, whereas if you look at the more stressed areas, the declines are substantially higher, say close to 40%. So, there’s been a huge distribution of returns across the ratings buckets. These differences in performance are not at all related to the virus, but it has added stress.
A country with a single A credit rating likely has adequate health care measures and can provide a fiscal response to cope with the crisis better than a country with a rating in the single B area, which likely lacks infrastructure and fiscal reserves to properly address the situation for even a small number of cases. In addition, a lot of emerging market countries rely on the tourism sector and with this current lockdown, there is a clear impact on economies that are more tourism-orientated.
The Central Bank Response
We have seen a strong monetary policy response from central banks across the world to provide support to their respective economies over the past couple of months. The US Federal Reserve (Fed) led in terms of developed markets, with a range of strong policy measures that even encompass asset purchases, including exchange-traded funds and high-yield securities.
The Fed has delivered, and not only for the US markets. There has been a trickle-down effect on emerging market debt as well in terms of keeping the financial system buoyant, but the bond purchase program in investment-grade corporate debt doesn’t really help emerging markets to a large extent, because emerging market debt is not on the Fed’s buying list.
In our view, it is clear to see there is willingness to do more from the Fed as well as the European Central Bank, and that is something the financial markets generally have embraced.
For emerging markets without that credit buyer of last resort in the form of the central bank, they would need to look to agencies or institutions such as the International Monetary Fund, where there is funding available specifically for emergency measures, which can bolster what is being done domestically.
While central banks are providing much-needed relief, there are some questions about the longer-term ramifications of moving into unusual and unconventional monetary policy areas. It could be quite difficult, if not impossible, to step back and unwind them. Therefore, there’s a danger that we move into a new world of quantitative easing in some of the stronger emerging markets. It’s certainly something we will be watching going forward as we return to a more normal state of economic activity. Emerging market investors know the dangers of monetizing the fiscal deficit in terms of inflation. While clearly something which is not a problem today, it could become a problem in the future.
Low Interest Rates Leave Investors Hungry for Yield
Emerging market economies were in generally good shape going into the current health crisis, and we think the fiscal and monetary responses from the leaders of a number of emerging market countries represent a symbol of progress.
Central banks across the globe have made emergency interest-rate cuts to near zero, leaving some fixed income investors hungry for yield.
While there is a lot of uncertainty in the current environment—and risk-aversion is likely to continue for a while longer—we don’t think the investor base for emerging market debt and other risk-assets is going to disappear. In this environment of low interest rates, the yields on emerging market debt and other risk-asset classes can look attractive. Therefore, in the medium term we still see some good opportunities within the asset class.
Emerging market debt has exhibited improving credit quality over the years. Successive crises over many decades have encouraged better governance, credit quality and liquidity in emerging markets, creating resilience for further shocks.
Certainly, the stress in the current environment is being felt most acutely in the countries with the weakest credit ratings, and we believe there will be continued deterioration where there is a lack of sufficient policy response. Some sovereign debt is trading at levels that to us look oversold, but we see potential opportunities as some uncertainty and volatility starts to ebb.
We will be watching how credit metrics are impacted after the current crisis ebbs, and how finance packages will be funded. We’ll be watching these policy responses closely as governments continue their fight against the virus.
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1. OPEC+ is an alliance of oil producers, including members and non-members of the Organization of the Petroleum Exporting Countries.