Emerging markets (EM) have recently faced an extremely challenging environment characterized by slowing global growth, geopolitical disruptions, continued inflationary pressures and severe tightening of global financial liquidity conditions.
Such a global backdrop warranted a cautious stance on EM assets through 2022. However, after the recent market decline, we now believe that attractive investment opportunities are emerging.
All types of EM debt funds have gone through a period of unprecedented outflows. This has coincided with a large revaluation of a number of EM fixed income assets at a time when monetary tightening cycles are well underway in most EM countries. We now believe that the EM debt asset class has largely discounted the recent global dislocations.
The turbulent global backdrop of recent years has also undermined the fairly strong macroeconomic fundamentals we see in selected emerging economies.
While we still believe that inflation is likely to remain entrenched given the huge increase in the global money supply built up during the pandemic, we expect some temporary easing of global inflationary pressures in 2023. Global demand, more favorable CPI base effects, a recent correction in energy prices and a significant easing of global supply chain shifts.
The impact of the Federal Reserve’s monetary tightening on the US economy is also now starting to bite. Commercial bank lending growth appears to have peaked in the US and global credit momentum is beginning to reverse its post-pandemic boom.
Our inflation model shows that a growing number of countries are already experiencing a marked slowdown in inflation, and this is likely to be rewarded by markets, particularly in EM countries where real interest rates are high and where central bank tightening is already in its final stages. . Figure 1 shows the latest signals from our inflation model.
Despite some deterioration in sovereign credit ratings during the Covid pandemic and periodic flare-ups of political tensions, a number of EM countries such as Mexico, Brazil, Indonesia and South Africa still display relatively strong macroeconomic fundamentals. This is due to a strong balance of payments, manageable financing needs, cheap real effective exchange rates and a credible monetary policy framework.
The asset class should also be supported by prospects for a revival of growth in China, following the full reopening of the post-Covid economy expected in 2023. This improving outlook can be seen in the differences in growth expectations, which are turning convincingly in favor of EM versus developed markets. (DM) for the first time in three years as shown in Figure 2 below.
This relative improvement in EM growth prospects has not yet been reflected in EM asset valuations, which remain at historically depressed levels across many EM debt subsectors. This is particularly the case with high yields on EM dollar debt, which is still trading near valuation levels seen only in past systemic crises, as shown in Figure 3 below.
Given the high level of yields in nominal and real terms, investors could be well rewarded in 2023 by holding select EM local and hard currency bonds in countries where policy frameworks are credible and macroeconomic fundamentals are reasonably strong.
In this regard, we favor local currency bonds in Mexico, Brazil, Indonesia, South Africa and a number of dollar debt frontier markets such as Angola and Ivory Coast. We also see some value in Central European bond and currency markets, but a convincing peak in inflation in Eastern Europe is required for us to see 2023.