Emerging Market Debt: Frontiers, Fundamentals, and Fractures

Edwin Gutierrez Head of Emerging Market Sovereign Debt
Jack Kirkpatrick Senior Director, Institutional Business Development

In contrast to the last energy shock of 2022, emerging markets and frontier markets are in a much better position, fundamentally speaking.

Geopolitical stress meets improving fundamentals – listen as our in-house emerging market debt experts unpack what today’s fractures mean for markets, valuations, and opportunity.

As geopolitical tensions and energy price dynamics reassert themselves, emerging market debt has shown a measured response. In Quarterly Perspectives’ latest episode on emerging market debt, our investment leaders explore why.

Head of Emerging Market Sovereign Debt Edwin Gutierrez joins host Jack Kirkpatrick to look back at the first quarter before exploring how markets are digesting rising geopolitical risk – and how today’s stronger fundamentals are helping keep credit spreads relatively contained.

Tune-in to listen to our Quarterly Perspectives episodes on Apple Podcasts, Buzzsprout, and Spotify.

Transcript

Jack Kirkpatrick: Hello, and welcome to the Emerging Market Debt Quarterly Perspectives Podcast. I'm Jack Kirkpatrick, a Senior Director at Aberdeen Investments. Each quarter, we break down the key developments in emerging market debt and share our insights on what lies ahead for the asset class. Today, I'm joined by my colleague, Edwin Gutierrez, Head of Emerging Market Sovereign Debt. Edwin, welcome to the podcast. It's great to have you on.

Edwin Gutierrez: Thanks for having me, Jack.

Jack Kirkpatrick: Well, let's get right to it. The Iran war has clearly moved to the front and center of investors' minds. Over the past month, the most pronounced market reaction has been an EMFX. And even that seems largely driven by an unwinding of investor positioning rather than a broad risk repricing. Why do you think spreads have so far remained relatively muted? And is the market being too complacent, or is this reaction justified?

Edwin Gutierrez: Yes, it's a great question, Jack. I think the reason why the reaction spreads space has been contained is that while local markets have priced in the impact of the war on inflation, they've yet to price in stagflation or a recession. Our house for you here is not projecting a global recession. Certainly there's going to be a slowdown in growth globally as a result of higher energy prices, But we don't think as of now, and this could change always because we are very much in a dynamic landscape, but as of now, that shock is not enough to tip us into a global recession. The caveat is that there remains a high risk that the conflict reunites sometime down the line after last night's announced ceasefire. And if this were to be the case, then additional destruction of energy infrastructure in the Gulf would likely occur, which would curtail energy supply even further in the medium term. Higher for longer energy prices would no doubt curb growth further and the result would more than likely lead to wider spreads. But it's important to note that this impact would not be just felt in emerging markets, but rather in all credit markets, with U.S. and European credit markets also seeing higher spreads, particularly high yield.

Jack Kirkpatrick: Edwin, looking at the fundamentals, how well positioned are emerging market countries to cope with elevated oil prices? or higher inflation for a prolonged period. And where do you see the greatest vulnerabilities, particularly among frontier markets, where food and energy make up a much larger share of the consumption basket?

Edwin Gutierrez: Well, Jack, in contrast to the last energy shock of 2022, following Russia's invasion of Ukraine, emerging markets and frontier markets are in a much better position, fundamentally speaking. You might recall back in the aftermath of the pandemic, emerging market and frontier countries and developed market countries to increase their fiscal deficits through household transfers and fuel subsidies. Growth also slowed in emerging frontier markets due to the pandemic, and with a combination of looser fiscal policy and slower growth meant that debt to GDP in emerging frontier market countries had been rising. In addition, during the onset of this last energy shock, a number of countries rode down their FX reserves to very low levels, defending currency pegs. And then with high inflation from food and energy prices combined with dwindling FX reserves, many frontier market currencies became overvalued and pressure on them mounted to the point that their currency pegs broke. And we had massive evaluations compounded, these compounded inflation pressures from food and energy prices. And central banks and financial markets had no choice but to raise rates aggressively to establish positive rates. And now we don't want to downplay the negative impact of energy and food this time around, but the picture does look a lot different, fundamentally speaking. In contrast to the fiscal largesse that defined the post-pandemic era in both emerging markets and also developed markets, By and large, young countries have been undertaking fiscal consolidation in the past few years, increasing their tax revenue bases, and also cutting fuel subsidies, oftentimes under the aegis of IMF programs. Now, combined with strong growth, both the numerator and the denominator of debt-to-GDP have been improving, meaning that debt trajectories have been declining in frontier and emerging markets. And this has been reflected by the positive ratings actions of the ratings agencies, which have overwhelmingly seen more upgrades than downgrades the past three years in emerging and frontier markets. In fact, we have a number of new countries that have obtained or re-obtained investment grade, countries like Oman, Paraguay, Serbia, and Azerbaijan. And we have a whole slew of countries which are knocking at the precipice of investment grade. So with a better fiscal picture in these countries, financing needs have fallen. And we've also seen a decline in market yields over the past few years. That's allowed frontier countries to regain market access, which has allowed them to finance themselves via the euro bond markets. And in the meantime, FX reserves have risen significantly in many emerging market frontier countries. So many of their currencies are now undervalued, and they've been further supported by the rise of commodity prices over the past few years. So we still have positive real rates in these countries. particularly in French market countries, and that serves as a buffer to absorb this external shock which the world is experiencing right now.

Jack Kirkpatrick: And how are you thinking about valuations and the outlook across the different segments of the EM market today, specifically local currency sovereigns, hard currency sovereigns, and EM corporates? And where do you see the best opportunities, and where are you more cautious?

Edwin Gutierrez: Yeah, as with all shocks, opportunities will arise. There are a number of countries where rate cuts have been priced out and where rate hikes have now actually been priced in, which we simply don't believe will actually pan out. So that's countries like Mexico, South Africa, and Hungary where the market is pricing in rate hikes. And if anything, we're going to get rate cuts from those countries in the coming months. And while our house view believes that the bid for US dollar will remain pretty strong in the near term due to the ongoing Mideast conflict, we still think there are opportunities, particularly in frontier currencies, especially amongst commodity-producing countries such as Kazakhstan, Uzbekistan, and Paraguay. And here, real rates remain very elevated as well. Along the same lines, frontier spreads have also widened by about 85 basis points with the recent lows, so we're getting better valuations. We continue to like oil exporters like Angola and Nigeria in this particular environment. And maybe not today, but Egypt has understandably seen significant spread widening along with currency weakness, which we will look to take advantage of at some point when the dust settles. And then if we look at the corporate market and emerging markets, this has been, they've been the bay outperforming year to date. And that's consistent with the historical trading pattern as we regard this as the most defensive segment of the asset class. We continue to see merit to the segment of the asset class as it is lower duration than its sovereign counterparts, which is part of the reason why it does have these defensive characteristics. When you look at fundamentals in EM corporates, leverage ratios remain structurally lower than comparable DM or developed market credits, while supply-demand dynamics remain favorable as net issuance continues to be negative overall, i.e. companies are paying down more debts than they are issuing. And I guess in terms of markets we're cautious, we remain cautious over the Middle East. While the ceasefires understandably generate buying interest for the Gulf region today, we remain concerned over the lasting impact in terms of damage done to the Gulf energy infrastructure. That's going to take years to repair. And in addition, you look at the region's ability to attract human capital as well as tourism flows. this is likely going to suffer some pretty significant damage over the medium term as well.

Jack Kirkpatrick: Thanks, Edwin. That sounds like a great place to bring the podcast to a close.

Edwin Gutierrez: Thanks again for having me, Jack.

Jack Kirkpatrick: And thank you to everyone who took the time today to listen in. If you enjoyed our episode today, then please download our other podcasts from our website or wherever you normally get your podcasts.

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