This is the second of three reports covering our traditional end-of-year review for emerging and frontier fixed income markets – we will publish our top picks for 2022 in the coming days. For our 2021 outlook, published last year, see here.
2022 outlook: Back to (new) normal
Heading into 2021, the mood was rather optimistic amid positive vaccine news, a 'blue wave' in the US elections making way for fiscal stimulus and a more multilateral approach to trade and foreign policy, and OPEC production caps supporting oil prices. But while these three themes largely held true, and US rates increased just modestly more than initially expected (consensus a year ago was for the 10-year to rise less than 40bps to 1.24% while today we are modestly higher at 1.46%, albeit with much volatility over the course of the year to get here, with the 10-year ranging from 0.91% to 1.74%), EM assets struggled in 2021. Expectations for a weak dollar also proved unfounded, with the Bloomberg DXY rising over 7% through 15 December and the JP Morgan EM Currency index falling by nearly 11%.
Next year, we expect Covid will continue to be a dominant theme, focused on the emergence of new variants (like Omicron recently) and associated changes in contagiousness, severity and vaccine efficacy. Worldwide, 46% of the population is fully vaccinated, reducing the severity of future outbreaks and the risk of lockdowns. However, this masks a wide divergence between countries, with less than 5% of the population fully vaccinated in low-income countries versus nearly 70% in high-income countries. This means that Covid will continue to be a major growth headwind for many EM in 2022, especially those that are heavily reliant on tourism. However, the tendency for successive lockdowns to be less disruptive than the last and the emergence of new post-infection treatments could help minimise the negative impact.
Alongside outsized policy support in developed markets (DM) relative to emerging markets (EM; with DM deploying an estimated 23% of GDP of above- and below-the-line fiscal stimulus in 2020-21 versus just 10% in EM and 4% in low-income countries), this will drive a two-speed recovery, with output and employment levels largely recovering to pre-Covid trends by 2024 in DM while EM are projected to still be c4% and 3% below trend, respectively.
Further, revisions to real per capita growth forecasts by the IMF between the October 2021 and October 2019 WEO updates have reduced the positive growth differential in favour of EM, slowing the rate of income convergence for many EM and potentially exacerbating political and social tensions for countries with endemically high levels of inequality, high unemployment and/or high inflation, which could become more of an issue in countries holding elections.
The dominant issue for EM assets, as this year, however, is likely to be the impact of rising inflation and the associated monetary policy tightening across the globe (which we have discussed at length here). With robust consumer demand in many DM as a result of unprecedented stimulus and a post-pandemic buildup in excess savings, and with supply chain and labour market constraints proving stickier than initially anticipated, many policymakers and investors have chosen to drop the word “transitory” from inflation discussions (as the US FOMC did at its meeting yesterday). While the Fed managed to begin (then accelerate) tapering asset purchases without major market disruptions, there is still a risk of a 'tightening tantrum' in 2022 if persistently high inflation forces the Fed and other DM central banks to hike rates more aggressively than expected, although presumably a lot of this may now already be discounted.
Indeed, with the Fed deciding yesterday to double the pace at which it slows its asset purchases (meaning it will be finished by mid-March), it has signalled (and markets are pricing in) three 25bps hikes by the end of 2022, a relatively hawkish shift in its forward guidance (FOMC members were evenly split between no hikes and one or two hikes in the September projections). The median FOMC member expects a rise in the fed funds rate to 2.1% by 2024 and 2.5% over the long term, similar to the size and pace of the 2016-19 tightening cycle but relatively modest compared with previous tightening episodes.
Against this backdrop, it could be another volatile year for EM assets. The good news, however, is that many EM central banks are staying ahead of the curve with pre-emptive rate hikes, which, along with the anticipated slowdown in global commodity price inflation, a gradual easing of supply constraints and favourable base effects, will help tame domestic inflation as the year progresses. In addition, pre-emptive policy hikes will widen the real interest rate differential with the US and other DM, potentially insulating EM assets from the impact of tighter DM monetary policy, to a degree.
Nonetheless, with the gradual withdrawal of unprecedented global liquidity, and a post-pandemic deterioration in debt sustainability metrics for most EM, investors will need to successfully differentiate between countries to navigate what could be choppy waters in 2022, with the underperformance of higher-yielding EM assets last year creating opportunities to generate alpha but also reflecting increased vulnerabilities in many smaller EM and frontier markets (FM).
To flag which EM could be most vulnerable in this environment, we recently updated our Taper Tantrum scorecard, which flags countries as vulnerable if they have low FX reserves, large gross external financing requirements, high external debt or debt service, low or negative interest rate differentials, and a high reliance on market financing.
The attitude towards EM assets in 2022 seems subdued after this year’s underwhelming performance. However, with DM rate hikes largely priced in and US bond yields expected to rise only modestly to 2% by end-2022 and 2.3% by end-2023, according to the Bloomberg consensus, the worst may be behind us, barring further adverse inflation shocks and negative Covid-related developments. In 2020, the IMF saw most EM currencies as being undervalued and the US$ as being c5% overvalued, and this has likely only increased following this year’s EM FX weakness and 2.5% real appreciation of the US$. Further, with the EMBI spread sitting 60bps wide of its pre-pandemic levels and over 100bps wide of its post-global financial crisis lows, there could be (limited) room for spread compression.
But with elevated external and debt vulnerabilities in many smaller EM and FM, it will be essential to monitor for signs of distress to avoid crises, while also screening for countries that may be able to generate outsized returns by implementing tough reforms to come back from the brink.
Below, we list some of the key global risks. Many of these are carry-overs from our 2021 outlook in modified form, while others are new. Global risks include:
The continuing threat from the coronavirus pandemic, including the emergence of new variants (like Omicron) and associated changes in contagiousness, severity and vaccine efficacy, as well as issues around vaccine hesitancy and distribution.
High inflation could persist longer than anticipated if supply chain and labour market disruptions prove to be more systemic issues, potentially feeding into price-wage inflation spirals and a de-anchoring of inflation expectations (which have so far remained relatively stable). This could force DM central banks to tighten policy more aggressively than anticipated and cause a “tightening tantrum” for EM assets as global liquidity is withdrawn from the system.
Consensus is for a relatively stable dollar (Bloomberg consensus forecast is 1% depreciation of the DXY by end-2022), but last year’s weak dollar consensus proved spectacularly wrong and the uncertain path of inflation and monetary policy could cause surprises in 2022 that could be unsettling to markets.
The timing, speed and shape of the global economic recovery. The gradual withdrawal of unprecedented stimulus could slow growth in DM, which alongside a lower growth path in China, could have knock-on effects for EM directly via trade and investment linkages and indirectly via commodity prices.
Geopolitical risks related to Russia/Ukraine, the Middle East and North Africa, and East Asia. Although US/China risk was top of mind last year, recent developments have brought Russia/Ukraine to the fore (see here and here). Meanwhile, tensions persist in the Middle East, North Africa and East Asia, with the disastrous fallout from the poorly executed US withdrawal from Afghanistan and subsequent Taliban takeover, post-election uncertainties and a reduction of US involvement in Iraq, ongoing Iran nuclear deal negotiations, an ongoing civil war in Ethiopia and autocratic slide in Egypt, Tunisia, and Turkey putting the credibility of the US commitment to democratic norms at risk, and simmering tensions in Asia over China’s role in the South China Sea and intentions towards Taiwan.
Election uncertainty in the developed world, with presidential elections in Italy in January and France in April providing an opportunity for populist candidates to make deeper inroads and roil markets. Meanwhile, in the US, the Democrats will try to hold onto their slim majority in Congress in the November mid-terms, which historically has led to a loss of unified control for the incumbent party. Either way, it will have a major impact on US policy, potentially influencing the size and composition of President Biden’s stimulus packages and, in the event of a Republican surge, putting his more ambitious policy plans on the backburner.
And, specifically for EM, risks include:
The timing, speed and strength of domestic economic recoveries, with EM generally showing relatively greater economic scarring/hysteresis from the pandemic. This could also alter income convergence paths and lead to greater social and political tensions.
Vaccine supply and the emergence of post-infection treatments in EM that have so far been left behind in the vaccination process, as well as the persistence of vaccine hesitancy for those with access to vaccines, and the ongoing impact of the pandemic on countries that are dependent on particularly impacted sectors, such as travel and tourism.
Fiscal consolidation presents a key risk to many EM, particularly smaller and frontier EM, where concerns over debt sustainability are greater and policy space limited post-Covid. Investors will continue to discriminate across markets in terms of the credibility of adjustment plans, along with issues over the timing and pace of consolidation.
Threats to central bank credibility from persistently high global inflation, with inflation expectations more easily de-anchored in EM, threatening to reverse the hard-won credibility gains in recent years for many EM central banks. Central bank independence could also be undermined by excessively loose fiscal policy (Sri Lanka) or political interference (Turkey).
Calls for an expansion of debt relief initiatives for EM, and especially LICs, could return, with the focus shifting to the evolution of the Common Framework with the expiration of DSSI by end-2021. Investors will keenly monitor restructurings in Ethiopia and Zambia for signs of how the Common Framework will work and gauge whether there could be more widespread participation (with interest so far limited to just three countries).
Lingering risks of sovereign default, with debt sustainability concerns and limited payment capacity potentially triggering more sovereign defaults. The pace of defaults slowed to just two this year from six in 2020, but idiosyncratic risks remain in some countries (Sri Lanka and Tunisia, in particular, with an additional seven countries yielding over 10% that are not yet in default – see here and here for a deeper dive into which countries are most vulnerable).
Concerns over the impact of China’s property sector distress, triggered by default at property developer Evergrande (we flagged concerns over a corporate default wave last year, but not specifically related to the property sector). Although the spillover to EM credit and portfolio flows appears contained after the initial shock, EM investors may be concerned about the potential real economic impact on China’s slowing GDP growth rate and the associated spillover to EM directly via trade and investment links and indirectly via commodity prices.
A number of important elections in EM could have implications for policy and/or political stability, including general elections in Angola, Brazil, Colombia, Hungary, Kenya, Korea and the Philippines, state elections in India, party elections in China and South Africa, and the start of campaigning in Nigeria. The regional spillover of the Taliban’s takeover in Afghanistan, civil war in Ethiopia and a power grab by President Kais Saied in Tunisia will also present lingering risks of unrest and violence in the Middle East and North Africa.
Oil and commodity prices. Following the near 45% rally in oil prices this year, markets will be keenly monitoring actions from OPEC and broader global supply and demand dynamics to gauge the direction of prices in 2022 (see here for the winners and losers from high oil prices). A nearly 25% ytd rise in both food prices and the Bloomberg commodity index have also pushed up inflation and shifted wealth from commodity importers to exporters. Markets will need to monitor commodity price trends to discern which countries will benefit and which are at risk.