Despite waning global growth momentum and rising inflation, strong fundamentals and relative valuations are offering compelling arguments for a strategic allocation to emerging market fixed income.
As the rebound weakens, global real GDP growth is expected to be lower in 2022 than in 2021. However, forecasts by the International Monetary Fund (IMF) still predict real GDP growth of +5.1% for emerging markets (EM) in 2022, versus a long-term trend of +4.9% (2008–2019).
Overall, EM have shown resilience throughout the Covid crisis and continue to display some strong fundamentals. Reforms across institutions in the last decades have given them the means to deal with domestic and external shocks. A firmer focus on financial market stability, independent central banks’ decision-making and exchange rate flexibility are now the norm.
EMs' current accounts have improved considerably throughout the crisis, as strong commodity prices led to additional revenues for commodity-exporting countries. A strong US dollar, including against EM currencies, has also helped shore up EM current accounts. The IMF, however, forecasts a moderate deterioration in 2022, with EM current accounts moving from USD 391 bn to USD 308 bn, whilst developed markets’ (DM) current accounts should also trend lower, from USD 246 bn to USD 200 bn.
EM also illustrated disciplined fiscal approaches during the crisis, with their debt increasing to a much lesser extent than that of DM. In addition, the monetary policy of quick tightening implemented by several central banks across EM, such as Brazil and Mexico, in 2021 also highlighted their experience in managing inflation risk and mitigating the impact on their economies.
While near-term inflation risks might be skewed to the upside given the global nature of this phenomenon, the resolution of supply chain issues and abating pressures from food and energy prices should help ease inflation in EM.
Importantly, EM central banks’ proactiveness in raising interest rates should now ensure ample capacity to loosen monetary policy if required.
China to rebound in 2022
EM projections are heavily skewed towards China, where growth is expected to remain subdued until the impact of policy support kicks in. China faced strong headwinds in 2021, partly due to the pandemic but also because of the property crisis. January 2022 is likely to be a critical month as several issuers in the real estate sector are due to refinance their bonds. However, with the latest data suggesting supportive measures by the Chinese government, a gradual easing of the short-term liquidity pressure on property developers should improve the market situation.
Chinese government authorities took advantage of the post-Covid recovery phase to implement reforms across key sectors such as manufacturing and real estate. Several of those reforms have caused a drag on growth in 2021, but ultimately remain consistent with the government’s long-term objectives.
Chinese authorities should now carefully use policy levers to manage any key risk to economic growth in what is likely to be a politically sensitive year for the Chinese government with the 20th Party Congress scheduled to take place in the second half of 2022. Overall, GDP growth is likely to be lower than in previous decades because of the reforms, but should improve meaningfully from the low levels of H2 2021.
Some geopolitical risks to monitor
Political risk in Latin America is likely to remain at the forefront of investors’ minds in 2022. National elections in Brazil and Colombia will be closely monitored, as will the ongoing protests in Chile and Peru where new governments were recently elected. In Asia, the Philippines will also be going into election year in 2022.
Turkey is likely to continue raising concern for markets, although limited foreign capital remains. Given the fragility of the current account, continued economic mismanagement could lead to further depreciation of the lira.
While a tail risk, the escalating tension between Russia and Ukraine needs to be monitored. Ongoing dialogue between the United States and Russia could help avoid escalation, and a potential agreement could lead to a significant repricing of Ukrainian bonds.
Valuations should attract investors once visibility improves
Data from J.P. Morgan suggests that flows to EM fixed income amounted to USD 50.6 bn in 2021. This is certainly a positive rebound from the USD 23.3 bn worth of inflows in 2020, but still far from the USD 116 bn and USD 67 bn recorded in 2017 and 2019 respectively.
Current valuations in EM fixed income make it an attractive point of entry for investors. After tactically delaying allocations into risk assets in 2020 and 2021, they should come back into the asset class in 2022, which will provide technical support. As always though, timing is difficult to ascertain given the complex transition phase we will face in 2022.
Some segments of the EM fixed income market are likely to present better risk-return opportunities than others, given the background of declining global growth and Fed monetary policy tightening. Selectivity will be critical.
