2021 Emerging Market Debt Outlook: As China Goes, So Go EMs – and the Going Is Good

Signs are pointing to a China-led recovery paving the way for above-consensus growth in emerging markets in 2021. China’s growth typically leads EM growth by roughly three months, with a boost that usually lasts 12 to 18 months. So the Chinese recovery is a good precursor for a further EM rebound.

The US Federal Reserve’s backstop will also remain a big support for emerging markets in 2021, helping reduce downside tail risk while bolstering the broader hunt for yield. Despite short-term post-election uncertainty in the US and mobility constraints in Europe, we remain comforted that the Fed and other central banks are committed to seeing economies through to recovery. Above all, we believe the Fed will keep rates low for (much) longer, provide forward guidance, and continue asset purchases through 2023 – and possibly on to 2025 – targeting low long-term interest rates.

But for emerging markets, the primary reason for our optimism is that China is revving up again as the world’s growth engine, and thanks to its renewed push for infrastructure, EMs stand to benefit. This may be contrary to more negative scenarios in many headlines, flagging rising debt levels and the fact that EMs don't have a central bank like the Fed that can bail out everyone. However, we would note that most EM central banks have been equally proactive in their easing of monetary policy. Emerging markets also stand to benefit from extraordinary liquidity measures provided by both the Fed and the European Central Bank (ECB) as a global search for yield continues to send waves of capital toward EM. 

What history tells us

Instead of following those headlines, we’re looking at real data to predict what's going to happen in 2021. And once again, the key fuel is that China is going back to investing in infrastructure and real estate. Therefore, we can dust off the history book and recall what it meant for EMs the last time this happened.

It seems we can literally create a blueprint from 2010, when emerging markets experienced a China-led boom followed by gradual deceleration, and similarly during the recovery in 2016 and 2017. After China's rapid growth over the last decade – in terms of GDP, China’s was almost three-quarters that of all other EMs put together in 2019 – this year, we see China’s contribution to EM GDP at 77%.¹ Whatever China does reverberates through the EM universe.

A lingering impact

But another question is: How long will this upcycle last? Is it just a three-month stimulus, and then back to the sort of structural slowing down in China and EM that we saw in the last few years? Or can we expect this new push to last longer?

When you consider that China leads emerging markets by about three months and that the impact on EMs lasts about 12 to 18 months thereafter, it suggests that 2021 could be a very healthy year for these markets. But history also tells us the kind of strong stimulus we're now seeing in China usually lasts longer than a year.

For the time being, we’re reliving a mini-2010, as China once again moves more toward fixed capital formation. And given the timelines, we’re quite confident that the EM rebound will be robust. Looking back, EM growth in the five years before the global financial crisis (GFC) averaged just below 8%, at 7.6%.² The five years after the GFC, it was around 6%.³ But 2021 will see growth probably in excess of 7%, after contracting by about 2.5% this year.⁴ The delta on those growth rates – from 2.5% to around 7% – is the biggest ever.⁵

Xi aims to make China a ‘moderately developed country’

Emphasizing China’s renewed focus on infrastructure are the government’s recently completed Fifth Plenum and the draft of its new Five-Year Plan and longer-term goals for the following decade, out to 2035. The latter includes a target of expanding the nation’s high-speed railway to 65,000 kilometers, almost double what it is today, part of a strategy officials are calling “Urbanization 2.0.” Plus, President Xi Jinping says he expects GDP per capita to match that of a “moderately developed country.”

China’s Fifth Plenum Outlines Ambitious Goals for 2035

Source: Morgan Stanley as of 30 September 2020. The 5% is a rough estimation, due to uncertainty in the assumptions of the key parameters (population growth, definition of GDP per capita of a moderately developed country, etc.). China’s GDP per capita was USD10,262 in 2019, and the target is assumed to be roughly USD20,000-USD23,000.

This is quite a vague target, so we took a lot of assumptions from the IMF and World Bank, as well as our own about population growth. Our calculations show that China needs around a 4.8% compound annual GDP growth rate to achieve Xi’s goal. This means China’s infrastructure buildout will likely remain really supportive for emerging markets in the coming years. Yes, China will continue its ongoing structural shift toward a more domestic consumption-oriented economy, but that will be on a slower trajectory compared with the boost in infrastructure spending.

So we see China as a growth engine for all the EM commodity exporters, including Brazil, Malaysia, Vietnam, Thailand, and Indonesia, over the next one or two years at least. Those countries will benefit more versus others. That also goes for frontier markets like Mongolia, where up to 80% of exports go to China because of its need for commodities.

LatAm corporates will benefit

Let’s use this backdrop to take a closer look at Latin American corporates that stand to benefit from China’s new infrastructure push. This sector isn’t just about commodity producers and exporters, given the region’s vibrant domestic companies that focus on LatAm consumption, but clearly, the major beneficiaries of strong recovery stimulus spending in China will be the big metals producers, particularly the miners.

Brazil is home to the world’s largest iron ore producer, which comes to mind. The company’s nine-month results show that exports to China now have gone up to 66% of its total from 59% just two years ago.⁶ And it's not just that China is taking a bigger percentage of exports. The company’s overall production levels have gone up a lot as well, so China is also taking a higher percentage of a bigger pie.

In short, virtually every company that contributes to China’s infrastructure projects ends up benefiting, and this will remain the case for the next year, three years, and five years. That includes companies such as key copper producers in Peru and Chile, Brazil’s iron producers, and a firm with major mining and smelting operations in Brazil and Peru.

LatAm commodity exporters aren’t the only ones benefiting. Suppliers to China’s expanding domestic consumer base are also reaping rewards, particularly the protein producers. Some of the overall increase in LatAm protein exports results from idiosyncratic issues in China’s pork supply prior to Covid-19. But those companies are also seeing new overall demand from China that’s not being met domestically, so their exports are filling that gap. The Chinese push to strengthen its consumer sector also creates much opportunity for LatAm food and beverage, pulp and paper, and industrial companies.

EM leverage outlook and default expectations

Another area where the headlines have turned out to be scarier than reality is EM leverage. In 2020, EM government debt levels increased by 10 percentage points of GDP and now sit at just over 60%.⁷ But in advanced economies, the increase in government debt was double that – 20 percentage points of GDP – and now sits above 120% of GDP.⁸ From a corporate perspective, EM corporate leverage ratios have historically been lower than those found in DM corporates, and that relationship remains intact despite an increase in corporate leverage among both EM and DM issuers. So from both a pure level perspective and also in terms of growth rates, the fear-mongering earlier this year definitely did not come to fruition. And we see a stabilization over the next few years.

What about default expectations? Here, too, the outlook is benign: We see declining defaults within both the corporate and sovereign universes, which provides further support to our very constructive 2021 EM outlook. Also keep in mind that history tells us expected levels of defaults are usually higher than realized defaults. That’s because the cost of default is so high for a country, and there are usually people willing to step in and help out.

Positioning views: EMs will keep cruising along

All that said, are we being too complacent or overly bullish in our positive EM outlook?  With China’s renewed emphasis on infrastructure in its new Five-Year Plan and long-term strategy, EMs should benefit through 2021 – and perhaps beyond. But such assumptions do not mean we are preparing for an environment of high growth and inflation; rather, we cite the China-led growth recovery as support for expectations of a central case macroeconomic scenario over the next 12 months. 

How do these trends affect our positioning views on EM debt heading into 2021? The consolidation of expectations for stable global growth and the technical support EM should receive from a global search for yield should support EM asset prices. We continue to see attractive return in high yield (HY) sovereigns, even taking into account their higher volatility relative to investment grade sovereigns. We see value in rebuilding sovereign HY opportunistically and in maintaining a long-term strategic allocation to investment grade corporates, which have historically outperformed on a risk-adjusted basis, as well as opportunistic allocations to high yield corporates. We’ll look for more clarity on EM growth and US dollar trends before venturing further into local currencies.

For more PineBridge views on what to expect across economies and asset classes in 2021, visit our 2021 Outlook page.

Footnotes

¹ Source: The IMF as of 30 September 2020.
² Ibid.
³ Ibid.
⁴ Ibid.
⁵ Ibid.
⁶ Source: Vale, PineBridge research as of 30 September 2020.
⁷ Source: The IMF as of 30 September 2020.
⁸ Ibid.

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