Emerging Markets Fixed Income, 2021 Review and Outlook

9 min read 18 Jan 22

  • After a difficult 2021 for emerging market (EM) debt, we examine some of the factors that could drive an improved outlook for the asset class in 2022.
  • While many of the factors behind lower 2021 EM debt investment returns remain in place – a ramp-up in global inflationary pressure, a strong US dollar and country-specific risks (notably China) – a healthy underlying economic recovery remains in place around the world, despite ongoing uncertainty from the Omicron COVID-19 variant. 

The value and income from a fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. Where any performance is mentioned, please note that past performance is not a guide to future performance. 

Emerging market sovereign debt delivered negative returns in 2021, particularly local markets which suffered from a double whammy of both currency depreciation and higher rates (see Figure 1). Corporate bonds fared better as the average credit quality of the corporate index is higher, notwithstanding specific sectorial problems (ie, elevated China real estate risk). Some of the reasons that led to the poor performance in 2021 may not be repeated in 2022, but there are still several drivers to be mindful of: 

1) Inflation

A big surprise for 2021. A combination of demand-side recovery and fiscal stimulus, supply-side bottlenecks, labour shortages, currency depreciation in some cases and a very accommodative central bank policy in the earlier part of the year led to the most sustained inflationary pressure seen in decades. Within emerging markets, Asia fared better than other regions, but most other countries experienced persistent pricing pressures. While the debate rages in the developed world over how permanent this shock is, we believe that in EM, its effects will be more transitory for the following reasons:

a) The policy response among many EMs has been far more pre-emptive. Many central banks have been tightening since mid-year and in many cases, real rates are no longer in accommodative territory.

b) Unlike some developed markets (DM), the room for fiscal stimulus is much more limited as debt levels have risen rapidly since 2020, in many cases. Less fiscal stimulus relieves the heavy lifting to be done on the monetary side.

c) Unlike some developed markets, particularly the US, many economies have not fully recovered from the 2020 recession and still have a negative output gap.

d) The removal of base effects is likely to reduce the yearon-year inflation figures, in our opinion. Commodity prices such as oil and certain foods are unlikely to continue rising at the same speed as they did in 2021. These items have a large weight in the consumer price inflation basket of emerging market economies.

e) We think EM currencies could fare better in 2022 – more on this in the next point.

Figure 1. EM fixed income performance breakdown (in US dollars) for 2021 

  Total
return
(%) 
Interest
return
(%)
Price
return
(%)
Spread
return
(%)
Treasury
return
(%)
FX
return
(%)
EM hard
currency
sovereigns
-1.8  4.9 6.4 - 1.6 -3.3 N/A
EM local
currency
sovereigns
-8.7 5.2  -7.8 N/A N/A -6.0
EM hard
currency 
corporates
0.9 4.7 -3.6 2.8   -1.8 N/A

2) Strong US dollar amid Fed tightening

Expectations of tighter Fed policy have contributed to the outperformance of the US dollar versus EM currencies and other major currencies in 2021. The better growth differential of DMs over many EMs and lacklustre capital flows into EM fixed income more broadly were also factors here. In fact, many EM currencies depreciated against the US dollar despite their central banks pursuing tightening policies and despite improved current account receipts (due in part to higher commodity prices).

Past performance is not a guide to future performance. Source: M&G, JP Morgan, December 2021. Benchmarks used: EM hard currency sovereign debt (JP Morgan EMBI Global Diversified Index) EM hard currency corporate debt (JP Morgan CEMBI Broad Diversified Index) EM local currency sovereign debt (JP Morgan GBI EM Global Diversified Index)

Something similar has happened before, in previous tightening cycles. EM local currencies posted negative returns for three years (2013-2015) during a previoustaper period, for example, but actually delivered a positive return in 2016, when the Fed started raising interest rates. This is a common misperception ‒ that EM currencies must fare poorly when the Fed tightens. In fact, they tend to depreciate in advance, so that by the time the Fed starts moving, they actually tend to perform relatively well. Because most EM currencies are fundamentally cheaper now compared to then (many were overvalued) and current account imbalances are far smaller – in many cases, they are actually in surplus – we believe that unless the Fed needs to hike interest rates by more than what is reflected on the recent dot plot estimates (three hikes for 2022, continuing into 2024) then EM local markets should fare better in 2022. We think this could be driven more from the currency side as opposed to rates, as there is still very limited scope for rate cuts given the Fed’s tightening stance.

Figure 2. EM fixed income historic performance, 2013-2021

  EM hard currency sovereigns (%)  EM local currency sovereigns (%)  EM hard currency corporates (%) 
2021 -1.80 -8.75  0.91
2020 5.26 2.69 7.13
2019 15.04 13.47  13.09
2018 -4.26  -6.21  -1.65
2017 10.26 15.21  7.97 
2016 10.15 9.94 9.65
2015 1.18 -14.92 1.30
2014 7.43 -5.72 4.96 
2013 -5.25  -8.98 -0.60

3) Global growth

With less fiscal and monetary stimulus, inflation eroding purchasing power and the world still battling COVID-19 (the Omicron strain now, and possibly other variants next), global growth is poised to slow in 2022. If anything, the projections shown in Figure 3 will probably be revised lower in the coming months, once we have more information of the Omicron impact. While a small headwind, we are far from a 2020-style recession. China is very likely to see a decline in growth, in our view, but has started easing policy though reserve requirement ratio (RRR) cuts and, should it decide to do so, has scope to provide selective support to its beleaguered real estate sector. (The RRR represents the amount of money that banks must hold as a proportion of their total deposits. Lowering that required amount will increase what banks can lend to companies and individuals.)

Figure 3. Latest IMF global growth forecasts (YoY) 2019-2022 

Past performance is not a guide to future performance. Source: M&G, IMF World Economic Outlook, October 2021 (latest data available). Note: order of bars for each group indicates (left to right): 2019 and 2020 actual, 2021 and 2022 projections. 

4) Geopolitical and political risk

The perennial wildcard. Potential flare-ups include Russia versus the West and Ukraine, and potentially more US‒ China tensions. We view these as low-probability but highimpact events which are not fully priced in by the market. In terms of elections or scheduled events, Q4 is likely to be particularly noteworthy. The China Party congress takes place in Q4, as do the mid-term US elections. The most important EM elections from a market standpoint will be in Brazil during Q4, and there is scope to cater to a large centrist electorate that is not happy with front runners so far (incumbent Bolsonaro against former leftist leader Lula). Latin America remains deeply divided in many countries. The administrations in Chile and Peru, in particular, will need to navigate a delicate balancing act. In Turkey, it is unclear whether President Erdogan will call for early elections before 2023. The country’s ongoing departure from orthodox policies remains concerning, but fortunately they are not causing significant contagion across asset prices outside Turkey itself. 

5) Valuations and sentiment 

Just as the sentiment towards EM debt was too bullish a year ago, it has now moved into the bearish camp, in our view, which could be a bullish signal in itself. Valuations have improved, particularly in EM local debt (foreign exchange and to a lesser extent rates) and select high yield issues. Investment grade spreads, on the other hand, remain expensive and offer little protection against higher US yields.

Excluding Chinese high yield issuers, corporate defaults are expected to remain close to current low levels as some deleveraging and/or liability management has taken place in 2021. Furthermore, commodity prices are higher and growth, even if it disappoints, is unlikely to cause a recession in 2022, in our view. Even within China’s real estate sector, which saw a few defaults already with more to come, contagion risk was rather small. If anything, Chinese local markets were among the top performers in 2021 (the yuan even appreciated against the US dollar) on the back of a strong current account and capital account restrictions.

Local government bonds behaved like safe assets, as the bulk of holders are still domestic investors, and, combined with the low inflation backdrop, managed to also outperform. It is also quite remarkable that despite the severe sell-off of the sector, the CEMBI index posted a positive return in 2021, reflecting, we believe, the well-diversified composition of the investment universe in terms of countries and sectors, and also the investment grade average quality at the index level. Sovereign debt restructurings could include Sri Lanka, El Salvador and Ethiopia, but none are systemic enough to cause contagion, in our view.

Round-up

Overall, we are less concerned about EM inflation in 2022, and selectively favour EM currencies with strong external account balances or where inflation may soon be peaking. Despite being more cautious on growth, we favour high yield versus investment grade debt, but recognise the ‘fat tails’ within this segment (indicating a higher probability of rare events) – as always, differentiation is key. In 2021, for example, we saw -30% returns for El Salvador and Ethiopia and even worse returns within the China property space, but distressed credits may also surprise on the upside, like Zambia (+50%). Our bias is to add local exposure and tactically manage the high yield component by actively managing bottom-up country and credit selection and position sizing.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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