2022 Midyear Emerging Markets Debt Outlook: Macro and Markets


2022 Midyear Emerging Markets Debt Outlook: Macro and Markets


We discuss our outlook for emerging markets vis-à-vis developed economies, including our expectations for global growth, inflation, and the risk of recession.

Markus Schomer
Welcome to PineBridge Investments podcast. I'm Marcus Schomer, the Chief Economist, here at PineBridge and I'm joined today by Jonathan Davis, Client Portfolio Manager, Emerging Markets Fixed Income. And we're going to discuss expectations for emerging markets. And while doing that, we'll cover some of the macro backdrop, a little bit on policy. And of course, we will talk about the markets.

Kicking off the podcast we want to start with the big theme right now that seems to be on everybody's mind, which is inflation. I'm, as the economist mostly dealing with the developed world. Inflation, to me is the big story. The fact that it has risen is quite obvious. But it's really the need for it to slow to sustain this business cycle that's what the key is in all our forecasts right now. If inflation continues to go up, I think we will have serious problems avoiding a recession.

The question, therefore, is whether inflation has peaked? In emerging markets, it doesn't seem to be that big of an issue. Yes, inflation rates are high everywhere. But whereas in the US and in Europe, you have to look at really long-term charts that go back all the way to the 80s, and sometimes even to the 70s, to find the last time that inflation rates were as high as they are today, in the emerging markets we are maybe elevated, but nowhere near as out of historical context, as we seem to be in many of the developed world economies. Jonathan, what is it like in emerging markets? How big of a deal is inflation? And is the turnaround in inflation and eventual decline in inflation as important for the forecast for emerging market macro prospects as it is really on, in my world for the US and for Europe, for example?

Jonathan Davis
Thanks, Marcus. And, you know, I think you said it best, when you referred to the magnitude of the increase, right? Certainly, inflation is higher across the globe. And emerging markets are definitely not immune to that, they are. The impact and pressure of higher energy prices, higher food prices, has seen an increase in inflation, broadly speaking across most parts of emerging markets, and there's a bit of difference among the regions that we can get to in just a moment.

But I would mention two things to start off with, when you think about the perception of the Federal Reserve is being a bit behind the curve and forced to sort of play catch up this year with their rate hike cycles. You know, that's been a very rare instance in our experiences when covering emerging markets, is that what we've had this time around, is that the EM central banks, were actually front running the Fed in terms of tightening monetary policy.

So, the sort of overheating component of the inflation story has been a bit pre-emptively averted by a lot of the central banks across emerging markets. And so that's helped rein in some of that non sort of base effect type of inflationary pressure, if you will.

The other thing to keep in mind when you do see the headline levels of inflation from a global EM perspective, and this really gets to so many of the conversations that we have when we discuss emerging markets, is it's such a broad group of countries, a diverse group of economies. So, the headline level might tell one story that when you start looking more granularly, by regions, by individual countries, you get a different story. And I mentioned that to say if you take out Argentina, Turkey, and Russia, where you have very high inflationary pressures for a variety of different reasons, if you exclude those countries, from your view of emerging markets, on a GDP weighted basis, inflation is really not that high above the recent trend, broadly speaking.

Now, certainly, as I mentioned, from the regional perspective, you do have higher inflation, above-trend inflation across most of Latin America. And certainly, also in emerging Europe. But you look in Asia where for many of the large economies in emerging Asia, you know, inflation is running at trend or even below recent trend levels.

And the same can be said to a lesser degree in the Middle East. So, yes, we would agree with you that the inflation concern is much more of a concern I feel on the developed market side and what that might mean to monetary policy, and then the macroeconomic outlook than just inflationary pressure, and what that might mean for the domestic growth, the net domestic economic activity across emerging markets.

Markus Schomer
Yeah, actually, I see the same thing and sort of in my world, there is a regional, distinct difference between what we're seeing in Europe and in the US, as opposed to Asia where the inflation numbers also in the developed Asian economies are significantly lower. Elevated, yes, but significantly lower than what we're seeing here. And if you tell me this, it's very similar in emerging markets, that also makes me more hopeful that those regions where inflation has picked up so much like particularly in the US that, that it will come down because the more common inflation drivers - the forces that push up inflation worldwide, and nowhere near as strong as what the numbers seem to suggest right now in the US or in Europe, which means there's some special factors there, which in many ways, are mostly driven by energy and the impact of the Russian invasion in Ukraine is having on natural gas and oil prices, which have a bigger impact, I think, on the Europeans and also on the US.

So, I'm kind of hopeful in my more optimistic inflation outlook, to hear you talk about inflation pressures in emerging markets to be far less out of sync with the more recent history, maybe should all of a sudden look at it more against the long-term averages instead of always just focusing on outright numbers, which sometimes don't tell you the full story.
And I also like the fact that you bring it back to the central banks. Maybe you can talk about that just briefly.

Also, I think it's absolutely true that the emerging markets’ central banks don't have the reputational problems that in particular, the ECB and the Federal Reserve have right now, having been way too slow to recognize, first of all, the inflation problem, but then reacting to it. I mean, the Fed at least is doing something, the ECB still is not doing anything, right, they just barely ended QE basically today, and then will start raising interest rates at the next meeting, but they still haven't done anything so, whereas the emerging Market central banks have been leaning against this inflation surge, for in some cases two years now.

So, if there were any sort of reputational scores, or ratings of central banks, I think emerging markets right now look a lot better than what the typical, the big, developed world central banks have done over the last few years. And I just want to give you a moment to react to that. That probably is something that should also impact confidence in those markets. Wouldn't you agree to that?

Jonathan Davis
I agree entirely, I would say, you know, I don't know that we could universally classify all emerging markets central banks as having high levels of credibility at the moment, but certainly, in aggregate, I agree with your assessment 100%, that they have been more credible, certainly, in this cycle, identifying inflation coming out of all the expansionary policy in 2020 and trying to get ahead of that last year, and doing so in a in a much easier environment to do so.

We had such robust levels of growth around the world last year that it was really a much more opportune time to start putting a bit of a dampener on monetary policy. So, I agree with your assessment there. And it also then filters through and you start thinking about growth outlooks for 2023 and beyond, it'd be much easier if across most of those emerging Market economies, if we start to see a slowdown, it's much easier for those central banks then to shift posture a bit and provide a bit more accommodation to help support those economies in the event of a global slowdown.

Then you could certainly, you know, that's the sort of, I guess, trillion-dollar question for the Fed is how do you navigate a soft landing when inflation is above 8%? You know, we're less likely to see that type of issue across much of emerging markets. As I mentioned before, the inflationary pressures are much more of that sort of base effect, pricing, base pricing effect type of variety. So, we're a bit more comfortable expecting a peak on your inflation levels, than you probably can forecast in the US. And therefore, you know, when you're thinking about those economies that will have that sort of buffer of monetary policy and the ability to ease in a slowdown, it certainly helps our outlook for 2023 across EM.

Markus Schomer
You are moving us already to the discussion about growth and sort of the recession risk. I'm not in the camp that we are heading for a recession in the US, I think that soft landing actually can be achieved. I would even say with relative ease because the growth restraining forces are not that strong. And then I don't really see a lot of significant imbalances that could trigger sort of these domino effects that we've seen in previous recessions, when you tip something and then because you know, households are over leveraged the housing market goes and then the financial system is too connected to the housing market, these kinds of dominoes, I just don't see them this time around.

So, could [we have] a very brief downturn in GDP growth, is that possible? You know, the definition of recession is two consecutive quarters of negative real GDP growth. Is that possible? Yes. But when I talk about a recession, I mean, something more meaningful, that also changes behavior, where we will have years ahead of us where companies, for example, are too, too cautious to really expand operations again, like what happened after the great financial market crisis. Or where households, for example, are too cautious to increase consumer debt or mortgage debt again, which is clearly not happening right now. I don't see any kind of protracted downturn like that on the horizon.

In the emerging markets, it's almost the opposite story. I feel emerging Market growth has been quite disappointing in the last two years, I've kept saying that this recovery that happened right after the pandemic was DM driven because it was kind of a stimulus driven and a lot of stimulus was in the developed world. Whereas emerging Market growth, if you look at PMI, indices have been consistently disappointing. But now we're getting to the point where in some cases, growth is rebounding. China is one of those examples. And I think you make a really, really good point, if growth continues to slow, the emerging markets will be the first to start cutting rates.

So, the first where the monetary policy stimulus will sort of come back in in the developed world, it will take a while before central banks are ready to cut rates again, but in the emerging markets, that could happen much quicker. So, could we even start to look at a story where the even near-term outlook looking into 2023 could be one where DM growth is slowing but could we start to make a case for EM growth could already be re-accelerating?

Jonathan Davis
To briefly answer that question, yes, I would want to make one point, you know, I think you made an excellent point with respect to EM growth, maybe being a bit of a disappointment in 2021 relative to developed market growth. And it gets to the kind of the issue, the kind of the line that we as bond investors walk right where we certainly are wanting to see robust, robust economic growth and secular growth and corporate earnings expansion.

But at the same time, as bond investors we are wary of sort of a deterioration of balance sheet. So, to get to your point on PMIs, with what it probably is factored into that, you know, is a taking of what has been very strong levels of cash generation among the corporate sector and a reduction of debt rather than a reinvestment or an acceleration of the capex cycle.

So I agree with your perception there. And then it's just a question of, you know, is that a good thing or a bad thing from where you sit and as a bond investor, it's not necessarily a bad thing. But moving back to your question, with respect to seeing, you know, an acceleration of growth. You know, so much of our conversations that we have with clients and prospective investors is typically boiled down to a small number of issues, right.

And as I said before, there is a long laundry list of potential threads that you can pull on with respect to emerging markets. But there always seem to be a several core issues that kind of always come up. And China is certainly one of them. And China earlier in the year was a key sort of risk off-indicator, if you will, as you had the zero COVID policy, resulting in quite draconian lockdowns across many of the largest cities in China. And you see that in Q2 economic data.

But looking ahead to 2023 and to get to your point on an emerging market acceleration, it's not too dissimilar. Now, obviously, not as dramatic a slowdown and probably not as a dramatic recovery, but not too dissimilar to the experience of 2020, where you had lockdowns, and then, you know, some support measures to help support a recovery.

So, in China, where we're talking, obviously, in the US, and at some point, also in Europe about, you know, tightening of monetary policy and potentially a drawdown of central bank balance sheets. You know, in China, we've had monetary policy easing, RRR rate cuts, we've had an easing of lending rates, we've had an easing of mortgage rates.

So, we've had an increase of liquidity in China that we expect to continue, we don't think we've seen the last of cuts to those, you know, RRR rate cuts to the prime lending rate, we expect to see some more cuts there. And we also had the pledging of substantial fiscal support primarily to come via infrastructure spending, maybe a sort of an adaption of the old playbook for China growth, and that sort of credit impulse of the policymakers to support growth through that means it’s certainly not going to be a departure of the future growth roadmap for China.

This is not saying a ripping up of that sort of shift of the economic growth engine, but we do expect to see a bit more fiscal spending to support that growth recovery following what happened in the second quarter. So, you know, again, looking forward to 2023, obviously, that means, you know, higher growth, certainly in China, which then influences what you'll see in Asia, but then obviously, all those countries that have strong economic links to China and their demand story.

Certainly, the other major economies within Asia, the Gulf and supplying of energy, and a number of the economies of Latin America where they have strong ties to exporting metals and exporting protein to China, all of those stand to benefit from a China driven sort of recovery in 2023.

It’s often the case, right, when there's an ebb and flow within maybe global economic sort of trajectories, we obviously have concern, and I agree with you that we probably are not headed for a protracted slowdown in the US, but a protracted recession. Actually, I do have a much more favorable view of the demand from China and what that could mean to our market.

Markus Schomer
I totally agree with that. And from a global perspective these counter cycles matter. The fact that global growth is not very synchronized right now - some parts are slowing, that's true, but some parts are accelerating. And I feel that sometimes, we miss to see the big picture, we're focusing only on the pieces that are slowing right now and then creating sort of the extrapolated story that - everything is slowing, the whole world is slowing.

But that's not necessarily the case. And if you have a global footprint, you can have a better view of how the pieces are moving in the global story. And we can’t talk about emerging markets without talking about politics.

It's actually quite funny. I talked a lot about politics in the last 12 months, because there were some big elections in Europe that could have had serious consequences. There's still a big election coming up in the US in the second half with possibly big consequences. But it seems like the focus is also shifting back towards the emerging Markets. There are a number of elections in Latin America that seemingly, if you just look at the headlines suggest sort of a left swing, a left lurch. And I think a lot of headlines are being generated by the upcoming Brazilian election.

My personal view, and again, looking at what's happening in the developed world where we've also seen a little bit of a shift back towards center-left kind of governments. We've seen it in Germany. We've seen sort of a center-left kind of confirmation in France, a number of other European elections have also gone that way. But it seems like there's this classic idea of conservative versus left wing governments, and the impact that it has on economies and markets is kind of fading.

First of all, there are a lot of conservative governments or parties right now that really pursue a much more populist, almost left-wing kind of policy agenda. Look at the Conservatives in the UK, even the Trump Republicans in the US, whether they are that way, and then some classic left-wing parties and governments pursue a more sort of nationalist, populist kind of policy, AMLO in Mexico as an example, he's not really governing, like sort of this classic textbook, left wing president.

And I wonder whether you think that is something that can be more generalized now for emerging markets? First of all, we shouldn’t even be applying these labels. And we still do apply the labels, but we shouldn't really be concerned anymore in a way maybe we used to be 10 years ago, whether the Labour party wins in Brazil, or whether a left-wing party is now in power in Chile, for example. Do you think that's the right way of looking at politics in emerging markets?

Jonathan Davis
Yes, I do. And I think you make a great comparison there to, I don't want to say abandoning - but maybe the change of the conservative tenets that for so long kind of underpinned, say, the Republican Party in the United States, or Conservatives in the United Kingdom, right? If you think about emerging markets, and maybe we can look at it through the lens of Latin America, because that's been sort of the biggest, or the busiest election calendar, at least this year, where Bolsonaro is kind of the sort of maybe lone standard bearer of the right, in that region. And yet you have the Brazilian government basically ripping up every sort of spending rule that has been on policy there to try and support essentially, economic growth, and maybe support his campaign.

So, there's been quite a bit of a non-adherence to the old rulebook, whereas, okay, Bolsonaro is a right leaning politician, and therefore, you would expect, austerity and more conservative management of the budget, and it has not been the case, certainly not this year.

And again, you mentioned AMLO. And I think, looking across Latin America and look, one of the key reasons for there being a higher risk premia across emerging Market assets is the political risks that exist within emerging markets.

And that's not that's not going to go away, overnight, or in the very near term. And Latin America, again, is kind of the very strong example of that. It doesn't have the best track record in terms of stability of governance across the region. And over the past several years, there's been a very clear rejection of political establishment, there's been a shift towards more leftist kind of sounding populism in elections across the region.

And we just recently had another one in Colombia with the election of Gustavo Petro. But what we've seen, is a very notable difference between how these candidates campaign and then how these candidates govern as presidents and administrations. And so, there has been less realization of those downside risks that markets react to in the run up to elections.

And then, Brazil being the next one, and Brazil is certainly being the largest economy within the region is always going to be a focal point. And with the election coming up this fall and the choice between Bolsonaro, I mentioned, as certainly the sort of the standard bearer of the right and Lula who very much comes from the opposite end of the spectrum. Obviously, Lula is polling ahead of Bolsonaro and, you typically would think, ‘Okay, this is a risk off event, and certainly we would expect some volatility to surround that election.’

But with the selection of Alckmin as Lula's running mate, where you have a career establishment politician from the center right, of that country's sort of political structure gives you a better indication of we're not expecting to see, a massive sort of tearing up of budget discipline and, undisciplined sort of behavior from a fiscal and maybe monetary policy perspective.

So, again, the lines have been blurred. And that's not been necessarily a bad thing. Certainly, elections have been events to follow, and certainly newsworthy events and risk events, in terms of our debt markets. But we have not seen that pendulum swing carry the day of policy, if you will, it certainly has carried political campaigns, but has not carried policy.

Markus Schomer
I really like the way you said it, the lines have been blurred. Yeah, I typically don't like that, because it makes analysis so much more complicated. But I think you are absolutely right. It's much, much more difficult now to assess the political risk coming out of an election, when there's a change in government and it's not just an emerging Market problem. It's the same issue in my world, in the developed world as well.

We did a lot of macro. But let's briefly also delve a little bit into the micro because what we do at PineBridge, is essentially we connect the micro and macro, we derive strategies that have a macro component, but most of what we do is micro. So, give us a bit of an update, how you see the emerging markets corporate sector doing against this kind of macro backdrop that we've talked about, and where do you see sort of opportunities for investment?

Jonathan Davis
I'm glad you brought that up. I think, to begin with maybe pulling in two of the topics we've discussed already, beginning with the path of monetary policy and US Treasury yields. Emerging market corporate bonds are a much shorter duration asset class, than emerging market sovereign bonds. So, from the perspective of how you think about investing within emerging markets in a rising rate environment, where you get a less sensitive asset class to increases in Treasury yields by looking at corporates. So that's number one.

Number two, and we talked about this already, in terms of the sort of restraint that was shown during 2021 and what that maybe took off of top line growth and how that may be disappointed you as an economist, had a much different sort of reaction among us as bond investors, right, where we saw, particularly in the corporate sector, a dedication towards reducing leverage, retirement of bonds etc. and so what we expect heading into 2022, EM corporate bond issuers generally had the lowest levels of leverage that they've had in the decade plus, and expectations are for the end of this year to actually close with slightly lower leverage levels across the market.

So again, you know that restraint definitely gives you comfort, if we are headed into a bit of a slower growth environment that we won't see nearly as much sensitivity in terms of the ability to service debt among the corporate issuers in our market. And then the final bit that I would pull on in terms of highlighting the corporate investment opportunity, and we could spend another, say 30 minutes really kind of going through the micro, on the EM corporate side of things. But, if we are headed towards a global slowdown, and particularly one where the US rates are so much higher than you find elsewhere, certainly amongst other reserve currencies, we’re probably thinking of an environment where the dollar maintains its strength.

And then the concern for EM investors is, well, what does that mean for my investments in emerging markets, and there and again, is another sort of supportive point to the corporate asset class. So, the estimates that we have are that just roughly maybe 12%, so one in eight of the EM corporate bond issuers are really vulnerable to FX and what I mean by that is more than half of the corporate bond issuance in the market are issued from countries that have either pegged or managed currency, so there's much less FX volatility for those issuers.

We have, another roughly 10% of the corporate bond market are issued from countries that have very robust current account surpluses, so probably less FX volatility facing those issuers as well. And then you have issuers financials who typically hedge FX risk. We have a large component of our market that is related to commodity revenues and those tend to be in hard currency revenue.

So again, less FX risk can actually just even be more of a benefit for those folks, not only do you have the higher prices, but you have dollar revenues and typically local currency costs. So again, probably a beneficiary from the stronger dollar market. And then what you're really left with when you talk about the more vulnerable areas, are basically sectors, and issuers that have domestic revenues and are within those countries that either are not in managed currencies or with strong current account surpluses. So, it really is another sort of nice selling point, if you will, of that component of our market as we head into what might be a bit more of a challenging year from a growth perspective in 2023.

Markus Schomer
That's a good summary, Jonathan, you're right emerging market fixed income is a very different animal to emerging market equities or equities in general, right, the equity markets pulling all in the same direction, whereas many of the things that are weighing on equity markets are actually helping some of the fixed income asset classes and I would say, particularly in emerging markets, as we said earlier on that in emerging markets, central banks were really early leaning against this inflation increase, and keeping it much more in sort of historical bands compared to what the developed world central banks have allowed it to surge into.

That credibility doesn't do much for the equity market, but it helps emerging market fixed income asset classes a lot, both sovereign and corporates in that respect. And you're right, there's some structural issues over the last few decades, like flexible exchange rates, for example, the growth in local markets, all that have been some structural improvement factors for emerging market fixed income, maybe emerging market corporate fixed income, in particular, so those are all really, really good arguments. So, I thought it was an interesting discussion. Also, for me to contrast some of the themes that I talk about in the developed world and to contrast those with what Jonathan is seeing in the emerging market, some of them are similar, some of them are different.

And that in itself, I think already creates interesting investment opportunities. That's what we do at PineBridge, we try to exploit those ideas and themes and make them part of the investment strategies for our clients. So, I hope you all found this interesting. I hope you walk away with a few ideas and maybe even with a desire to dig a little bit deeper into emerging markets and learn a bit more where the investment opportunities are.

You can certainly find a lot of this on our website, pinebridge.com, which can be a really good stepping stone in finding some of these ideas that we talk about, in general, in our strategy meetings and to our clients. So, I'm left with thanking you all for listening. And thanks, Jon, for being on the podcast. And I hope we see many of our listeners again on some of our next podcasts. Thank you very much.


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