NNIP: Emerging market debt: seven reasons to be selective in 2022

2021 has been a difficult year for emerging market debt with high inflation and changing monetary policy weighing on markets
As the global growth recovery moves to the next stage, emerging market debt is becoming less synchronised
The year ahead is likely to present selective opportunities for active management in emerging market debt
This year has been a challenging year for emerging market debt. While the global economy has grown strongly, many emerging markets have lagged. Higher inflation has triggered a change in monetary policy expectations with both developed and emerging market central banks tightening policy. As the expectations for higher US rates have come forward, it has pushed core rates higher, while a stronger US dollar has overshadowed the benefits stemming from higher commodity prices and new IMF Special Drawing Rights (SDR) allocation for emerging markets. However, NN Investment Partners (NN IP) sees seven key factors driving a better outlook for selective investment in emerging market debt (EMD) in 2022.
Marcin Adamczyk, Head of Emerging Markets Debt at NN Investment Partners, comments: “As the global growth recovery is moving to a next stage, synchronized moves in emerging market debt are becoming less likely. Regional, sectoral and country differentiation all start to play a bigger role in the allocation decisions. Combined with the heightened uncertainty about the exact timing and path of events, the room for active management and dynamic rotations is very much alive in emerging market debt. While undoubtedly challenging, this macro environment and the themes described below, offer a chance to explore valuation and perception mismatches and benefit from them.”

Seven key themes in EMD for 2022

1. Growth: differential between emerging markets and developed markets with China slowing
The global economy is expected to continue its healthy recovery – albeit not as strong as in 2021 and possibly subject to potential downside risks around the Omicron variant. Emerging economies are expected to grow in 4.5-5.0% range and developed markets at 4.0-4.5%. The growth differential is the lowest in a number of years. China is slowing (from nearly 8% to around 5.0%*) and emerging market countries need therefore to be prepared for the new composition and pace of Chinese growth. We expect a substantial growth dispersion on the regional level within emerging markets, with Asia and Central Europe leading and Latin America and Africa likely lagging behind. Identifying countries that benefit as regional supply chains for high growing developed market countries, such as Mexico for the US, and at the same time have no major fiscal cliffs in 2022, will be the key opportunity for the year.

*Source: IMF/Bloomberg

2. Inflation in developed markets and emerging markets
Inflation has become a global theme and is visible in both developed and emerging markets. FED Chair J. Powell has now retired “transitory” when describing inflation. However, it is expected that the further re-opening of the global economy (subject to virus risk), combined with base effects in energy and food prices, will start to contain the increases and contribute to inflation peaking in the first quarter of 2022. It is likely that the overall inflation level will be set higher than the pre-Covid averages. The emerging market countries where CPI is likely to peak earlier will have more policy room and also will become less sensitive to adverse capital flows. Investors will for example look for countries where combination of previous rate hikes, composition of trade balance and magnitude of base effect as well as the weight of food and energy in CPI basket all open up the likelihood of early peak in CPI.

3. Developed markets vs emerging markets central banks: interest rate cycle disparity
The market is looking now for clues on timing and patterns of future rate hikes from the Fed, while the ECB is expected to be more patient. Many emerging market central banks are already well advanced in normalizing the rates and unwinding QE programs from the levels of 2020. In aggregate, emerging market central banks have hiked rates by over 150bps al-ready and further rounds of hiking are expected. With the exception of Turkey, all other emerging countries have been tightening. As CPI peaks and emerging market debt starts to offer real yields again, it may be a turning point.

4. Emerging markets readiness to navigate through Fed tightening
Emerging markets have been hiking rates earlier than the developed world, allowing for FX weakness to act as adjustment valve. Many also show favorable current account dynamics (overall EM-ex-China current account has been in 1.6% of GDP surplus in 2021*). There is little of the fragility seen in ‘taper tantrum’ of 2013, when economies were overheating and current accounts stretched. Additionally, the vast majority of emerging debt is now in local markets with reduced foreign ownership and increased local investor base. This should allow for better weathering of FED tightening than has been the case historically. Opportunities are there where orthodox monetary policy is combined with current account surplus, and where there’s limited reliance on external financing or foreign participation in the local market.

*Source: Bloomberg/JP Morgan

5. Commodity prices and their impact on emerging markets balance sheet
Emerging markets benefit from higher commodity (energy and metal) prices. Over two-thirds of the investable universe are commodity net exporters and in many cases the windfall in government revenues coming from the commodity exports is substantial. The market was quick to recognize the inflationary impact of higher commodity prices, yet the positive impact for emerging market commodity exporters has been largely overlooked as growth worries, lack of vaccination progress and larger stock of debt accumulated during Covid crises came to the forefront. Investors should look for opportunities in commodity exporting countries with healthy balance sheets, as the market moves from beta to alpha on the commodities theme. Additionally, green transition will be supporting commodity prices amid China slowdown.

6. Election calendar and idiosyncratic emerging markets stories
2022 is going to be a year of major elections in many emerging market countries, including large ones such as China (potential 3rd term for President Xi) and Brazil (likely Bolsonaro versus Lula) as well as elections in Colombia, Hungary and Philippines. While typically a source of heightened volatility in the run-up to the event, they can offer two types of opportunities for active managers: either for a positive change or simply a fall of volatility past the event.

7. Green transition and emerging sector of emerging markets labelled bonds
As green transition is gaining momentum and importance, a number of emerging market countries have stepped up efforts in that front and are issuing green, social and sustainable bonds. With the market growing rapidly in this space, more diversification and choice is available for investors to reward those efforts and for emerging market countries to benefit from preparing a solid and credible frameworks for such issuance. Investors should look for positive direction of travel, strong frameworks and openness for engagement. We believe that including emerging market countries in capital allocation in order to solve global problems and meet Sustainable Development Goals will further support and accelerate this trend.

Marcin Adamczyk concludes: “The prevailing uncertainty around virus developments including the new Omicron variant in the recent weeks still remains elevated, contributing to increased volatility and huge tail risks around any future central macro scenarios. Adding to that is a set of regime shifts that took place this year, from geopolitics, through to central banks policies and a shift in China’s regulatory priorities and attitude to growth. All of these factors have had prominent consequences for EM assets performance in 2021 and will likely remain as driving force for 2022 as well.”

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