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EM debt in the 2020s — investing in an unstable world

Emerging Market debt is closing the decade on a strong footing. With double-digit total returns and below-average volatility, investors have enjoyed a solid performance this year, prompting capital to flood back into the asset class after a difficult 2018.

Of course, this has come against the backdrop of an uneasy balancing act between loosening global liquidity and a synchronised growth slowdown. Indeed, the divergent narrative between strong markets and weak fundamental data has caused some to question the durability of this year’s risk asset rally.

There have been few places to hide this year from the swoon in economic activity, either in industrialised nations or in the developing world. In the US, consumers remain confident, buoyed by low interest rates, rising incomes and a vibrant labour market. At the same time, trade uncertainty has weighed heavily on business sentiment, exports and investment.

With longstanding global supply chains under threat, manufacturing productivity may drop further. The growth picture outside the US has been much worse, with Europe hampered by weak demand and Brexit risk, while export-oriented EM economies remain highly sensitive to global trade protectionism.

A structural slowdown . . .
However, the trend of slowing EM growth stretches back much further than the recent Sino-US tariff escalation. In many ways, the golden era for emerging markets was the first decade of the millennium after China’s WTO accession in 2001. That period was defined by rapid growth in EM GDP per capita, currency appreciation and booming global trade. China’s investment-led expansion during those years consumed vast amounts of commodities, which buoyed much of the developing world.

The second decade, by contrast, has been much less kind to EM. Deglobalisation, falling productivity and the decline of multilateralism have all provided stiff headwinds for growth despite abundant global liquidity.

A maturing global tech cycle, epitomised by smartphone and data centre saturation, has greatly hampered Asian exports, once the engine of EM growth. At the same time, China’s structural transition away from an export-centric, resource hungry, low-income economy towards a domestically oriented, consumer driven, middle-income economy has also weighed on EM’s output.

Nonetheless, EM fixed income, particularly hard currency debt, has enjoyed strong risk-adjusted returns in the period since the global financial crisis. While the asset class remains volatile and risky, the benefits to investors — growth, yield and low correlation to developed market assets — are compelling. So, what will the next decade bring for investors attempting to navigate the EM debt landscape?

The near-term outlook . . .
The short-term fundamental outlook appears cloudy, with subdued growth, stagnant exports and continued global trade tensions. Moderating economic activity, coupled with subdued inflation and negative output gaps, has not gone unnoticed by EM policymakers.

Central Banks — from Mexico to Malaysia, Serbia to Sri Lanka — have been quick to shift gears and move towards policy easing cycles to stabilise activity. With the US Federal Reserve unlikely to tighten policy anytime soon, this trend seems set to continue into next year, assuming currencies remain stable.

This has provided a healthy environment for EM local currency bonds, the yields of which have dropped sharply over the past 12 months. Developing countries still have plenty of space to cut rates further given their elevated real policy rates. G10 central banks, on the other hand, do not enjoy this luxury and are quickly running out of road on monetary policy.

Beyond monetary policy . . .
This leaves the prospect of fiscal easing as the next obvious gateway for loosening global financial conditions further. The recent large corporate tax cuts from India and increased budget deficit targets in South Korea may act as a blueprint for developed countries in this regard. However, any increase in the already sizeable global debt burden, now estimated at more than 320 per cent of GDP, according to the Institute of International Finance, will act as a further structural impediment to long-term global growth.

In EM, much hope this year has been placed on Chinese fiscal stimulus to help solve the growth dilemma although, so far, the policy response from Beijing has been underwhelming. While the Fed still sets the global cost of capital, it is China that sets the global pace of growth. Tax cuts and increased space for local government bond issuance have been welcome, but it is clear the hurdle for outsized credit extension is high.

A repeat of the major credit impulse in 2009 and 2015, which boosted demand for commodities and weakened the US dollar, seems unlikely to materialise, for a few reasons.

Firstly, the slowdown in Chinese growth, corporate earnings and employment has not been as acute as those previous episodes. Secondly, China no longer benefits from the financial stability of a large current account surplus. Finally, China’s debt levels are now much higher, prompting Beijing to reprioritise financial stability over a growth rebound. Any additional Chinese fiscal stimulus from here is likely to be modest, domestically oriented and ultimately less beneficial to EM’s commodity exporters.

This offers something of a conundrum for EM credit markets, already grappling with growing risks of sovereign debt restructuring in high-profile countries such as Argentina, Lebanon and Zambia. At the same time, market technical factors for hard-currency EM debt remain supportive given the persistent global demand for yield in a low interest-rate world.

With a 5 per cent plus coupon at present, few alternative asset classes can offer the same income generated in EM external debt, yet pension funds and insurance companies are still structurally under allocated to the asset class. By the same token, EM remains under-represented in global bond indices, given that it is now contributing more than half of the world’s GDP.

Rising temperatures — politics and climate . . .
Recent developments also suggest the 2020s may herald a new era of heightened political risk in EM. While the stability of governments has never been far from the minds of investors, the extraordinary pace of populist protest during the autumn in countries such as Chile, Bolivia, Egypt, Iraq, Lebanon and Ecuador has shocked markets.

Governments are increasingly coming under extreme pressure from populations frustrated with economic inequality, disenfranchisement, corruption and fiscal austerity. In the past, political risks in EM tended to peak and trough predictably with the electoral cycle. The new reality, however, is that social media can spark almost instantaneous unrest and instability for the political elite. As a result, EM political risk premia look set to rise into next year.

In much the same vein, climate change will be a major challenge for EMs over the coming years. This has already disproportionately impacted developing countries and political pressure from the electorate is likely to force governments around the world to accelerate remedial action.

Over the coming decade, those EM countries and companies that fall behind the curve on a progressive decarbonisation agenda are likely to be punished by impatient activist investors, forcing financing costs higher. We may also see the onset of green trade wars, with countries imposing carbon border taxes on each other, creating winners and losers in the EM world. Given the exponential rise of climate change on the political agenda, particularly in northern Europe and Australasia, this no longer seems a radical or far-fetched concept.

Thinking further ahead . . .
More structurally for EM, the next 10 years are likely to be dominated by a battle for global hegemony between the US and China. This extends well beyond tariff escalation and into areas such as artificial intelligence, cyber security, robotics, military prowess and geopolitical influence.

We may witness a short-term detente on trade between Presidents Trump and Xi over the coming weeks, but deeper agreement on more pertinent issues will remain elusive. This is likely to weigh on the long-term prospects of both the Chinese renminbi and EM currencies more broadly, given their sensitivity to global growth and trade.

EM FX has, for the most part, underwhelmed over the past decade. A meaningful rebound in global growth and a period of US dollar weakness remain prerequisites for a sustainable outperformance of local markets relative to hard currency credit.

At the same time, favourable demographics, a powerful and longstanding anchor for potential growth, will continue to provide a significant tailwind for EM debt. The coming decade is likely to see a dramatic rise in investment and capital flows into frontier market regions such as sub-Saharan Africa, which are witnessing rapid acceleration in labour force expansion.

A unique opportunity . . .
The global transition towards the highly disruptive third industrial revolution over the coming decade also offers EM an opportunity. EM has long suffered from an infrastructure deficit but now has a unique chance to build from scratch and catch up with the rest of the world.

With the marginal cost of technology, transportation and renewable energy production falling rapidly, EM needs to reorient itself away from the resource-exporting economic model. Developing countries should prioritise their infrastructure, investment, education and governance towards innovation in the digital economy, automation and resource sustainability.

While many of these longer-term themes will be difficult for EM debt investors to trade, they will certainly ensure the asset class remains as vibrant and colourful as ever over the coming decade.

Paul Greer is portfolio manger, emerging markets debt and FX, at Fidelity International.

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