In the evolving landscape of global finance, emerging markets have recently experienced a subtle transformation, raising critical questions about the durability of their recovery and the potential challenges on the horizon. This analysis seeks to unveil the complex interplay of factors influencing these markets, offering insights into whether recent concessions have been sufficient and what the future may hold.
To comprehend the current state of affairs, it’s essential to acknowledge the backdrop against which these developments have unfolded. Historically, emerging markets have been highly sensitive to shifts in global economic dynamics, often bearing the brunt of volatility in the face of international monetary fluctuations. A year ago, a pronounced vulnerability emerged: the remarkably low yield achievable across various credit markets, including those targeting emerging economies. This issue was exacerbated by tight spreads amidst an environment of exceptionally low core yield rates, setting the stage for the challenges that would unfold over the course of 2021.
The narrative of 2021 has been predominantly shaped by a noticeable uptick in core bonds yields, propelling the credit market into a new phase of performance. Despite these headwinds, it’s noteworthy to mention that emerging markets, on a relative scale, have fared reasonably well, even achieving commendable returns in certain segments. The high-yield sector, in particular, has demonstrated resilience, albeit with returns not entirely compensatory for the risks entailed. In comparison, a strongly rated investment grade corporate floater has displayed parallel performance dynamics to risky high yields during this turbulent period.
This year has not been favourable for fixed-income investments at large. With inflation expectations fuelling a sell-off in the bond market, any form of fixed income that pays a constant return is facing potential erosion, especially in longer maturities. However, the pursuit of additional yield in emerging markets could serve as a palliative measure, offering some relief against the backdrop of a global uplift in economic activity.
As we delve deeper into the implications of synchronized global growth and rising market rates, a brighter economic forecast begins to emerge. The International Monetary Fund projects a robust recovery, with global GDP growth anticipated at 5.5% in 2021 and 4.2% in 2022, a remarkable turnaround from the -3.5% contraction in 2020. The narrative for emerging markets and developing economies is even more optimistic, with an expected growth of 6.3% this year. EM Asia remains the powerhouse of growth, while Latin America is poised for a recovery after a tumultuous 2020.
Despite these optimistic growth forecasts, the shadow of higher long-term rates looms, presenting a challenging obstacle for emerging market sovereign issuers contending with longer duration refinancing costs. A resurgence in dollar weakness could potentially alleviate some pressures, as a broadening global recovery diminishes the attractiveness of the US dollar, thereby benefiting emerging market currencies.
A pivotal moment for emerging markets could be the Federal Reserve’s discussion on tapering its asset purchase program. Such a move, if introduced against a favorable economic backdrop, may not necessarily perturb risk assets. However, it remains a substantial factor for risk asset caution, signaling the nuanced balance between optimism and vigilance required in navigating these complex market landscapes.
Initial signs of a shift came with the receding activity in the primary market for sovereign debt issuance in early 2021, reflective of relatively modest refinancing needs. Nevertheless, expectations lean towards an uptick in issuance, driven by the need to finance cyclically elevated deficits and additional pandemic-related expenditures. While the scale of these fiscal burdens is more pronounced in developed markets, emerging economies are not entirely exempt, particularly in regions like Latin America.
The journey through 2021 has witnessed a deceleration in portfolio flows into emerging markets, evidencing the increasingly challenging backdrop that could dampen inflows moving forward. This signals a broader stress on credit performance across the spectrum, reminiscent of 2013’s “taper tantrum” scenario, highlighting the cyclical vulnerabilities inherent in these markets.
Looking ahead, the prognosis for emerging markets is mixed. The anticipated synchronised upturn in global growth during forthcoming quarters is poised to provide a buoyant framework, potentially counterbalanced by a weakening US dollar. Nevertheless, the narrative of higher interest rates persists, poised to exert sustained pressure on credit exposures across various fronts. Within this complex mosaic, high yield opportunities may offer a semblance of refuge, contingent on the stability of the overarching risk environment. This encompasses both hard currency and local currency segments, with the latter presenting incremental opportunities for performance in light of currency fluctuations.
In synthesizing these multifaceted dynamics, it becomes evident that emerging markets are at a critical juncture. While recent concessions have provided some degree of stabilisation, the path ahead is fraught with challenges and opportunities alike. Investors and policymakers alike must navigate this terrain with a careful blend of optimism and caution, recognizing the nuanced interdependencies that characterise the global economic landscape in this era of uncertainty and change.
