Emerging markets (EM) credit spreads have tightened significantly since reaching once-in-a-decade wides in March and April 2020. The rapid turnaround was driven by the bottoming-out of fundamentals, the US Federal Reserve supportive actions and attractive valuations. Even after the strong rally, NN Investment Partners (NN IP) believes that EM hard currency (HC) presents a compelling investment opportunity at current spread levels. Developing countries stand to benefit from supportive lending programmes and near-zero rates in developed markets, and historical return patterns show that the period of tightening may be far from over.
The Covid-19 crisis sent emerging market credit spreads to their widest since the global financial crisis. As NN IP stated at the time, this spread widening represented a monumental opportunity for EMD investors. Despite record-high issuance, spreads rallied furiously and are no longer at extreme levels, but they remain close to minor crisis levels such as the 2011 Greek debt crisis. In this environment, NN IP believes there is still value to be extracted from the asset class.
Historical data demonstrates that spreads will likely tighten further. “During the global financial crisis, in the year that started eight weeks after spreads peaked, EM sovereign credit returned almost 30%,” says Leo Hu, Co-Lead Portfolio Manager EMD HC at NN IP. “Similar trends can be observed following less severe sell-offs, such as the Greek debt crisis.” Therefore, the risk/reward points to remaining invested in EM credit markets, as they are very hard to time and liquidity can be fickle. EM credit will also continue to generate meaningful carry in a world where developed market rates stay close to zero for an extended period.
The economic recovery in EMs is far from over. Oil exporters are still facing the negative effects of reduced prices and volumes, with Brent crude futures down 30.9% for the year to date, while travel to popular tourist destinations is unlikely to increase significantly before 2021. Emerging markets are also at risk from potential tail risks such as a resurgence in virus cases. Many people in poorer economies must expose themselves to the virus to survive, which facilitates its spread, and further lockdowns could be socially and economically devastating. “Nonetheless, the overall trajectory is gradually turning positive,” says Hu. “Countries are booking incremental progress in treatment, testing capability, health equipment supply chains, social distancing and wearing of masks. These small gains are helping markets consolidate.”
EM countries also benefit from support from the IMF and other multilateral agencies, which should help them through the crisis. The IMF is deploying significant financial firepower to help countries deal with the emergency, while the G-20’s Debt Service Suspension Initiative suspends payments until end-2020 for the poorest member states of the International Development Association. This suspension means that those countries need not go back to Eurobond markets and can better manage existing debt. NN IP has identified Angola, Cameroon and Mozambique as Eurobond issuers that stand to benefit from this initiative.
China, the largest bilateral lender to EM, is also exhibiting encouraging signs of increased transparency and providing relief. First, it followed the G-20 DSSI initiative to give relief to the poorest countries, and subsequently President Xi Jinping vowed to cancel interest-free government loans and rework some commercial obligations of African countries. Angola represents an early test case for this initiative. “Angola’s economy is under stress because of Covid-19 and the oil price collapse, and approximately 50% of its total external debt is owed to China,” explains Hu. “According to local press reports, China agreed on a 3-year debt moratorium, which helps to relieve the liquidity pressure and free up cash.”
Perhaps the biggest supportive factor for emerging markets has been the US Federal Reserve, which rapidly moved rates to zero and commenced an aggressive buying programme. This helped stabilise global credit markets and helped the US primary credit markets to reopen, which in turn helped EM primary markets to open and gave EM sovereigns a much-needed source of funding. “With short-term US rates set to zero, selected EM central banks can aggressively lower their own local rates to help revive their economies,” says Hu. “Having the Fed set the model of large-scale bond purchases has also made it more acceptable for EM countries to use monetisation to fund themselves through the crisis and shelter their domestic economies.”
NN IP has identified the key tail risks for EM economies as a virus resurgence, US-China tensions and US political risk. Still, strong technicals and attractive valuations keep the asset manager positive on EMD hard currency in the near term. In addition, historical return patterns show that EMD hard currency can continue to surprise positively several months after a crisis.