10 July 2020

Emerging Market Debt in the Covid-19 Era: Perception Versus Reality

Emerging Market Debt in the Covid-19 Era: Perception Versus Reality

As the number of new Covid-19 cases rises across emerging markets, concerns are growing that these regions are particularly vulnerable and will experience more severe public health consequences relative to developed markets. Cases across many parts of EM are indeed on the rise, with Latin America in particular becoming a significant source of new infections. Yet perhaps a more important trend is EM’s contribution to the decline in global mortality rates over the same period.

The global Covid-19 mortality rate has fallen from a peak of 0.6% in April to below 0.10% currently. Latin America, described as the “new epicenter” of Covid infections by many news outlets, has experienced Covid-related death rates of roughly one-third those in the US and Europe – helping bring down the global average.1

The ability of emerging markets to effectively manage the risks associated with the pandemic thus far should give investors greater confidence that some alarming projections related to EM debt may reflect a misunderstanding of EM more than true vulnerability.

Three trends underlie EM’s lower Covid mortality rate

Lower coronavirus mortality rates across EM are indicative of three longer-term trends that will likely support EM assets well beyond this year.

First, EM populations are substantially younger than those of developed markets. Beyond offering a level of protection from the worst effects of the coronavirus, the relative youth of EM populations should allow these regions to maintain a faster rate of economic growth than their DM counterparts, which will face challenges related to supporting aging populations. 

Second, while poorer countries may have weaker healthcare systems, many larger EM countries have healthcare systems that are comparable to those of developed nations. The investments that many EM countries have made in their healthcare systems have also played a crucial role in keeping Covid-related deaths relatively low.

Finally, the investments in healthcare are indicative of a third long-term trend that will likely support EM: Investments in infrastructure and positive governance trends have resulted in broad improvement in institutions across EM, which should in turn support continued long-term economic growth.

Many Larger EM Countries Have Healthcare Systems Comparable to Those in Developed Markets

Source: Global Heath Security, Macrobond, United Nations as of 31 December 2019. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change.

Fact, or myth? Emerging markets lack capacity to stimulate economic recovery

Many believe that EM countries are saddled with high rates of inflation that limit central banks’ ability to stimulate their economies during a downturn. Yet falling inflation across EM has provided central banks with room to cut policy rates from their historical highs entering the year, and many have already taken decisive steps to ease monetary policy.

Moreover, misconceptions about a presumed lack of budgetary discipline may lead some to conclude that EM governments can’t provide sufficient fiscal stimulus to support their economies. However, over the past four years, governments across EM have actively worked to reduce their primary budget deficits (see chart). Improved balance sheets provide EM governments with greater fiscal flexibility.

EM Has Capacity to Provide Monetary and Fiscal Stimulus

Real Policy Rates and Primary Budget Balance (% of GDP)

Source: Bloomberg, IMF as of  31 March 2020. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the Investment Manager, are valid as of the date indicated, and are subject to change.

Lower inflation and budgetary discipline not only enable emerging markets to address the current downturn; they may also allow for a meaningful reduction of risk associated with EM currencies and sovereign credit – both of which would improve the long-term risk-adjusted performance of EM debt.

EM external debt dynamics: A thirst for yield meets Fed support

Investors who are fearful that pressure on EM external debt – arising from a lack of sponsorship and market access, growing deficits and debt burdens, and weaker currencies – should keep in mind several key factors.

First, while EM public debt levels have increased, gross debt levels as a percentage of GDP are roughly half those of developed markets. Additionally, the bulk of EM sovereign funding is done in local currency markets, which are not susceptible to risks arising from foreign exchange and are nearly 10 times as large as the external sovereign debt market ($10 trillion versus $1.2 trillion).2

Second, external debt markets are also reflecting technical support that might otherwise be overlooked. Since the Federal Reserve pledged unlimited purchases of investment grade corporate debt and high yield exchange-traded funds (ETFs), the demand for yield has been met with a surge of issuance across all public credit markets. EM external sovereigns certainly took part in this deluge, as April set a record for monthly primary issuance. The demand for yield has engendered strong demand for bonds both up and down the credit spectrum. Many lower-rated sovereign and corporate issuers are coming to market with deals that are in many cases priced with minimal to no new-issue concession, with spreads similar to (or lower than) those in the secondary market.

Lastly, in developed markets, historically high levels of public sector debt, along with low structural inflation and aging populations, are all likely to keep rates low for longer. Under such conditions, EM debt markets will likely continue to enjoy support from strong demand in a global hunt for yield.

Are EM corporates really weaker than their DM counterparts?

The global demand shock caused by Covid-19-related lockdowns has already resulted in widespread rating actions across both DM and EM credit markets. Nearly 8% of the investment grade EM corporate market has been downgraded to high yield to date in 2020, and some sell-side expectations are calling for record fallen angels among EM corporates this year.3

Such expectations support the misconception that EM corporates have weaker credit metrics than their DM counterparts. For investors, it’s important to remember that sovereign risk is contributing to the majority of expected fallen angels in 2020. On a standalone basis (without considering sovereign risk), the rate of fallen angels within EM corporates is likely to be only slightly higher than that of DM corporates, and would mark only the second time over the past 12 years that EM outpaced DM in the rate of corporate fallen angels. The lower rate of fallen angels within emerging markets historically is indicative of stronger credit metrics, as most EM corporates typically carry less leverage than their developed market counterparts.

Given the role of sovereign risk in credit ratings, perhaps default rates serve as a better indicator of pure credit risk within the EM corporate market. We would expect EM corporate defaults to range between 3% and 4% of the overall high yield market, compared to 5%-6% for US high yield. This would also align with recent history: US high yield defaults have exceeded those in EM in 11 of the past 12 years.3

Bottom line? Separating perception from reality remains crucial when evaluating emerging market debt.

Footnotes

1 Source: Worldometer as of June 2020
2 Source: Source: IMF, Bloomberg, Barclays, J.P. Morgan as of 31 March 2020. For illustrative purposes only.
3 Source: J.P. Morgan, S&P and Fitch as of 30 June 2020.


Disclosure

Investing involves risk, including possible loss of principal. The information presented herein is for illustrative purposes only and should not be considered reflective of any particular security, strategy, or investment product. It represents a general assessment of the markets at a specific time and is not a guarantee of future performance results or market movement. This material does not constitute investment, financial, legal, tax, or other advice; investment research or a product of any research department; an offer to sell, or the solicitation of an offer to purchase any security or interest in a fund; or a recommendation for any investment product or strategy. PineBridge Investments is not soliciting or recommending any action based on information in this document. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author, may differ from the views or opinions expressed by other areas of PineBridge Investments, and are only for general informational purposes as of the date indicated. Views may be based on third-party data that has not been independently verified. PineBridge Investments does not approve of or endorse any re-publication or sharing of this material. You are solely responsible for deciding whether any investment product or strategy is appropriate for you based upon your investment goals, financial situation and tolerance for risk.

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