This is the second of a series of reports covering our traditional end-of-year review for emerging and frontier fixed income markets, the outlook for the year ahead and our top picks for 2023. The last of these will be published in the coming days.
For our outlook for 2022, published last year, see here.
Over to you, central banks...
Much like we saw in 2022, we think financial markets in 2023 will be dominated by inflation, and expectations over when the global tightening cycle will end, if not reverse. If major central banks – including the Fed – can get it right, with a soft landing for the global economy, lower bond yields and a weaker dollar, then emerging markets could enjoy a virtuous circle. However, if inflation proves stickier and we see further upside inflation surprises, volatility will continue and EM could be in for yet another challenging year. Geopolitical risks could also weigh on sentiment and the impact will be hard to predict.
2022 does, however, end on a more optimistic note, following a strong monthly performance in November, after an otherwise brutal year. Indeed, after two consecutive years of negative performance, including what is on pace for a record decline in 2022, it wasn’t long ago that many market participants were calling for the death of EM debt as an asset class – although, in our Global Themes, we outlined our case for why those concerns are exaggerated. But there has been a shift in tone in recent weeks, with many commentators now calling for EM debt to stage a rally in 2023 – helped by attractive valuations – as it claws back some of the losses of the past two years.
The primary driver of this shift has been the perception that the Fed is nearing the end of its hiking cycle and that rate cuts could follow in H2 23 as inflationary pressures wane and recession risks rise. Markets are now pricing in another c100-125bps of hikes to a terminal rate of nearly 5% in mid-2023 followed by c50bps of cuts by year-end, while the 10-year US bond yield declined from c4.25% in late October to 3.5% by the end of November, on the back of a larger-than-anticipated decline in October’s CPI print.
If the Fed does reach the end of its tightening cycle in mid-2023, as widely anticipated, then EM assets could indeed perform well. We recently calculated a median annual return of 7% in the two years following the end of a Fed tightening cycle over five cases since the mid-1990s, while peak rates could also signal the end of the two-year dollar rally (with the DXY rising 7% in 2021 and just over 10% YTD, albeit down from a near 20% rise over the first nine months of the year).
However, we have a few problems with this thesis. First, we still think it is too early to say definitively that inflation is on a durable downward trend in the US, and, despite the positive surprise in October, forecasts have generally been far too optimistic on this front so far this year. If inflation does not moderate as quickly as expected, there is a risk that the Fed will have to go beyond the projected 5% terminal rate to prevent a more sustained breach of its target. Moreover, the Fed’s preferred inflation gauge (core PCE) may be stickier.
Second, we think markets are misplaced to think that a recession in the US will automatically lead to rate cuts by the Fed, which is likely to hold at the terminal rate until there is clear evidence that inflation is on track to reach its 2% target and is unlikely to reverse course without a sharp rise in unemployment. Indeed, forward guidance from Fed officials has repeatedly stressed the likelihood that rates will have to be 'higher for longer', although markets somehow still seem disappointed every time it is repeated.
As such, while markets have belatedly and partially adjusted to the 'higher for longer' reality, we think they have overreacted to last month’s positive inflation surprise in the US and expectations may well have to adjust for a higher and/or more prolonged terminal rate. Against this backdrop, EM assets could be hit by the double whammy of a global recession and tight financial conditions (although our recent research shows a weak relationship between US growth and EM growth/returns).
Lastly, we are still reluctant to call time on the strong dollar cycle. Indeed, the consensus projection was for a weak dollar heading in 2021 and for a broadly unchanged dollar heading into 2022, but it has continued its upward march (rising c12% in real effective terms versus the 2021 average despite the IMF’s assessment that it was c9% overvalued at the time). With the Fed’s hiking cycle soon coming to an end, the dollar may continue to weaken, but, given the extent of the recent sell-off, it is possible that the shift is already priced in (or even overpriced) and that a partial reversal may be in store, especially if the pivot doesn't play out as expected.
Even if market pricing of the Fed's rate path turns out to be correct, there is still a risk that the dollar will strengthen if the European/G10 rate cycle turns out to be more dovish than expected (for example, due to a steeper recession in other developed markets relative to the US) or if geopolitical risk or other unforeseen shocks cause a flight to safety. As such, whether driven by a hawkish Fed or external factors, USD could well buck expectations for a third straight year and continue its upward march.
The dollar has strengthened by a more modest 4.5% YTD relative to EM currencies, partly reflecting more proactive monetary policy tightening in many EM (with a median rate hike of 300bps YTD and 400bps since Q3 21 across our sample of 66 EM). But, with many EM reaching the end of their hiking cycle as rates rise and inflation falls in developed markets, an erosion of the positive real rate differential for EM could turn into a headwind for EM currencies (it has already fallen by 300bps YTD relative to the US, but is still 1.5% higher).
Nonetheless, we still think that 2023 will be a far better year for EM assets relative to the last two painful years. After peaking at 9.25% in October, the yield on the Bloomberg EM Sovereign Index fell below 8% at the end of November (with the HY yield falling from c12.75% to c10.75% and the IG yield falling from c6% to c5%). Still, EM sovereign dollar bonds have not looked this cheap in years, with the 2022 sell-off potentially unlocking some pockets of value (especially among HY names).
Indeed, at 387bps as of 5 December, the option-adjusted spread (OAS) on the Bloomberg EM Sovereign Index is still 82bps wide of the 2015-19 average and 103bps wide of the post-pandemic low. However, breaking it down by rating, the IG index is actually 65bps inside the 2015-19 average and just 10bps above the post-pandemic low, while the HY index is 306bps wide of the 2015-19 average and 177bps wide of the post-pandemic low, showing that HY credit is much cheaper relative to history than IG, which has been resilient on a spread basis.
That said, the relative underperformance of HY credit compared with pre-pandemic levels is at least partly justified by weaker fundamentals, with improved resilience relative to the 2013 'taper tantrum' among larger EM versus greater vulnerability among the 'fragile frontiers'. With global financial conditions likely to remain tight, more frontier markets may follow the likes of Sri Lanka and Zambia and be forced to restructure their debt, so investors will have to be discerning in their hunt for value in the HY space.
Our debt sustainability and external liquidity indices provide a starting point for flagging the most vulnerable countries as we head into 2023, with Ethiopia, Mozambique, Jamaica, Tunisia, Laos, Mongolia, Pakistan, Kenya, Ghana, Rwanda and Egypt some of the most vulnerable countries across the two (excluding those that have already defaulted). Many of these come as no surprise, with markets already pricing in a high risk of distress in many of these names.
More to the point, yields have surpassed 10% in one-third of countries in the EM index, locking many EM out of the market, with EM bond issuance running at half of last year’s pace. Those countries with no market access, limited reserves and large external financing needs will be forced to rely on ad hoc support from bilateral and multilateral partners to plug their external funding gaps and avoid default, with Ethiopia, Pakistan, Ghana and Tunisia flagged as particularly vulnerable by this metric (excluding those in default) and Mozambique, Bolivia, Mongolia, Rwanda and Kenya also flagging as vulnerable (lower-right quadrant).
Specifically, we highlight several countries in our coverage universe that we consider most vulnerable, overlaying our vulnerability scorecards with our country-level research. In particular, we identify six countries as being at most risk of default in 2023: Ghana, El Salvador, Ethiopia, Maldives, Pakistan and Tunisia. These are largely idiosyncratic risks and a broader EM rally may do little to help ease default concerns in these countries.
We see Pakistan as one of the most likely countries to default in 2023 (although it successfully retired its US$1bn Sukuk earlier this month and remains optimistic that it will be able to get its IMF programme back on track despite the massive economic damage caused by the recent floods). In any case, with bonds trading well below our estimated cUS$50-70 recovery value, we think the risk of default is already more than priced in and maintain a Buy recommendation on Pakistan’s eurobonds.
Tunisia has bought itself some time by securing a staff-level agreement on an IMF programme, but we are circumspect about its ability to keep the programme on track and think default is likely still inevitable over the medium term without a sustained policy shift (albeit perhaps not in 2023).
Likewise, Egypt has bought itself some much-needed runway by agreeing to the IMF programme and securing significant financing from partners in the Gulf but will remain vulnerable over the medium term, and Kenya continues to perform well under its ongoing IMF programme but has little margin for error as reserves continue to decline.
In Ethiopia, it is still unclear if bondholders will be included in its debt restructuring under the Common Framework. While eurobonds are a negligibly small portion of Ethiopia’s debt stock and service bill, official creditors may condition relief on private sector involvement to satisfy the comparability of treatment principal and, with reserves plummeting below one month of imports coverage, there is diminishing runway to turn things around ahead of the US$1bn eurobond maturity in December 2024.
Ghana has already announced that it will seek to restructure both its domestic debt and foreign bonds, although details are still vague and it remains current on its international bonds (it launched its domestic debt exchange on 5 December). However, with most eurobonds (excluding near maturities and the guaranteed 2030s) trading at the US$30s price level, the risk of default is already more than priced in. Market attention will focus on recovery prospects and potential spillovers to other distressed African issuers.
El Salvador faces the risk of default on a US$667mn bond maturity on 24 January 2023. While the authorities launched a second cash tender offer on 30 November (the offer was due to close on 6 December, unless extended) in order to help reduce the size of the maturity, the amount allocated for the purchase was small and the extent of bondholder participation is unclear. But, even if the payment is made, we think default concerns will persist given the ongoing concerns over the lack of a credible and coherent financing plan, limited policy options, and still high debt service costs (after the '23s maturity, there is a bit of space until the next maturity – the smaller '25s – but interest on the bonded debt is still cUS$500mn a year compared with reserves of US$2.5bn). Bond prices already reflect some amount of distress (with prices around the high 30s, low 40s excluding near maturities) although we think they could be vulnerable on the downside if default materialises.
We think default risk is elevated in the Maldives, amid limited financing options and large financing needs, while official reserves are falling. Reserves have fallen by 18% this year. The government plans tax rises and is considering other measures to address fiscal vulnerabilities – with double-digit fiscal deficits and public debt over 120% of GDP – while the level of reserves could force a deeper adjustment. However, 2023 is an election year which may reduce the government’s appetite to pursue, and stick to, needed reforms. And, as we know from Barbados and Suriname, new governments can choose to default. We don’t think this is reflected in current bond prices (cUS$79 mid on the MVMOFB 9.875% 2026s).
For those countries that do default, we can draw lessons from recent and ongoing restructurings, which are likely to set some major precedents. Whether inside or outside the Common Framework, we observe that many restructurings are suffering from delays in getting the official sector creditor committee to the table (mainly due to China) and disagreements with private sector creditors (mainly due to lack of early engagement by the official sector and difficulties with sequencing). These issues will need to be ironed out to prevent their reoccurrence in the future.
Overall, we are optimistic about the prospects for EM assets in 2023 in both the hard currency and local currency spaces. However, there is still much uncertainty surrounding the path for global inflation and growth and the associated trajectory for monetary policy in developed economies, which could present further headwinds for EM assets in the year ahead (especially given the extent of the recent rally, which may prove excessive and/or premature).
Below, we list some of the key global risks to the outlook, many of which are carry-overs from our 2022 outlook.
High inflation could persist for longer than anticipated, forcing central banks to tighten more aggressively, or lead to over-tightening, which could result in a deeper-than-expected recession.
A global recession or sharper-than-expected slowdown could transpire, weakening fiscal positions, corporate and household balance sheets, and leading to social unrest.
Russia’s war in Ukraine could escalate, continue for much longer and spill over to other regions (negative) or end in a durable negotiated peace (positive).
The impact of China’s zero-Covid policy and recent protests, will impact China’s growth trajectory and, consequently, demand for goods and commodities exports from and investment flows to EM. As most global forecasts seem to assume some gradual easing in China’s zero-Covid strategy, the possibility that this might not happen presents downside risks to global and EM growth prospects, while there may be more limited upside if restrictions are removed more quickly than expected.
Uncertainty about the price and availability of oil and other key commodities, especially in Europe as we head into the winter;
Broader geopolitical tensions, especially between the US and China, China-Taiwan, US-DPRK, and the associated potential for further fragmentation and localisation of already-strained global supply chains; and
Strong dollar. Although the consensus is for a weaker dollar, on the back of expected lower US rates, what if the consensus is wrong again (eg on the back of an even more dovish rate outlook in Europe or other non-US G10 currencies and/or flight to safety triggered by geo-political shocks)? And given the extent of the recent rally, is there scope for reversal (see above)?
Threats to international financial stability caused by, for example, i) weakness in NBFIs or fund outflows leading to the collapse of major asset manager, ii) potential weakness and wobbles in European banks and associated spillovers, which could be aggravated by weaker growth/recession, and/or iii) spillovers and unknowns from the crypto crash (eg FTX).
And, specifically for EM, risks include the following.
Challenges in implementing post-pandemic fiscal consolidation across many EM, particularly smaller EM and frontiers, especially if growth weakens.
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;
Important elections in several key EM that could have implications for policy and/or political stability, including Nigeria, Kazakhstan, Turkey, Pakistan and Argentina, among others;
Lingering default risks for countries with large external financing needs and limited market access (see above); and
Lower- or higher-than-expected oil prices, which will hinge on the global growth outlook and the ability/willingness of OPEC+ to exert control over prices, with attendant risks for oil exporters if prices are lower than anticipated and oil importers if they are higher than expected.
From a longer-term perspective, the narrative of outsized growth in EM and convergence between emerging and advanced per capita incomes over time is still intact, but has undoubtedly been slowed by post-pandemic scarring and the associated rise in economic vulnerabilities in many EM. And with structural reform taking a backseat to macro stabilisation over the past couple of years, it remains to be seen which EM, if any, will be able to take up the mantle of structural reform and move their economies towards a more sustainable and robust growth model in the years ahead.
In the meantime, while brighter horizons are likely in store for EM after two brutal years, 2023 will yet again be fraught with risks and uncertainty, and it is still too early to say whether EM assets are out of the woods.