This article, the second in a two-part series, discusses some of the factors holding emerging markets back, what may cause them to shift, and where we see potential opportunities.
In the previous post, my colleague Carol Lye highlighted two key tailwinds supportive of emerging markets (EM) in 2021: an easy U.S. Federal Reserve (Fed) and robust Chinese growth. Add to that buoyant commodity prices, rapid vaccination rates in the developed world, and a global—almost frenzied—search for yield. All these factors are obvious to anyone who reads the financial news. And yet, local-currency EM fixed income has struggled in 2021. What is holding it back? We would argue that there are two pieces still missing from the puzzle. One is that investment-grade EM sovereigns do not offer enough yield yet. The second is that speculative-grade EM have looming fiscal concerns. There are signs that both factors may be changing for the better.
Among Investment Grade, Chile and Poland Stand Out
Let us start with investment-grade EM. In the midst of the unprecedented COVID shock, many EM central banks quickly shifted to extraordinarily easy monetary policy. On some measures, monetary policy is even easier than it was following the global financial crisis (GFC) of 2008 (see Chart 1). So far, this recovery has been much faster and with less structural overhangs than the one following the GFC. However, policy rates that made sense in the summer of 2020 may no longer make sense as the world starts getting vaccinated and emerges from a year-long quarantine. While it is true that higher-quality EMs never offered particularly high real rates for foreign investors, the flows of capital go both ways. There is widespread evidence of local EM investors “dollarizing” their savings and prepaying U.S. dollar liabilities amid low domestic rates. For the moment, central banks worldwide have reaffirmed their intent to remain lower for longer, but money markets have started to price in rate normalization in many of these countries. Better rates of return domestically are likely to incentivize locals to remain in their home currencies. Thus, a key factor this year will be the shifting central bank reaction function in the face of changing growth and inflation outlooks. Chile and Poland stand out as two countries with central banks that may turn hawkish later this year, which would in turn support their respective currencies.
Speculative Grade Poised to Surprise Positively
For speculative-grade EM sovereign bonds, the worries are more structural in nature. Debt loads were already high heading into the COVID-19 pandemic. Fiscal stimulus to counteract the shock of quarantine exacerbated the problem. The politics of fiscal consolidation are challenging amid still high unemployment rates. Market concerns are most apparent in BB-rated EMBI hard-currency spreads, which remain near historical wides, reflecting a great deal of pessimism (see Chart 2).
The upside of low expectations is that it does not require much to surprise positively. For this exercise, we will focus on the larger countries. Within this group, there are some positive trends that could work in their favor this year. Brazil has been in recession since 2016 but is likely to post positive gross domestic product (GDP) growth in 2021. South Africa just announced a reduction in planned debt issuance due to upside surprises in tax revenues from the mining sector. The traditionally dovish Turkish central bank has been tightening policy since July of last year. Tough challenges still lie ahead for BB-rated countries, but better global growth and some well-intentioned policy decisions present upside to what remain very skeptical valuations.
The Push and Pull toward Emerging Markets
To summarize, there are plenty of global “push” factors to encourage investors to move out of the U.S. dollar, not the least of which are an eroding trade balance for the U.S. and the Fed’s shift to average-inflation targeting. We also see signs of increasing global “pull” factors to coax investors into EM. In our view, 2021 will be about timing that inflection point at which skeptical valuations meet a confirmation of improving fundamentals.
Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.