The durability of the recovery of emerging markets in recent months remain unclear
- It is clear that emerging markets have suffered considerably as a result of the COVID-19 crisis
- However, the extent to which the severe initial shock was the result of an interruption to liquidity flows is open to debate
- Growth in emerging economies may have taken a permanent hit but, at the same time, emerging markets could become more attractive for those searching for yield
- There are important differences between different emerging markets and between asset classes within the sector
It is neither the beginning nor the end. There is no doubt that the emerging world has suffered greatly as a result of the COVID-19 pandemic and the associated containment measures. But it is still far from certain exactly how hard the hit will be or the extent to which it will have a lasting effect.
Perhaps it is best to divide the discussion into two. There are many developments which are generally regarded as uncontentious: large numbers have already died as a result of the virus and it looks certain many more will do; domestic lockdown measures have hit emerging economies hard; economic output has also suffered as a result of the slump in demand from the West (figure 1); bond spreads widened enormously from late February until late March before narrowing considerably after that (figure 2); and there are important differences between different emerging markets and sub-asset classes.
At the same time, there is still a lot that remains open to debate. For example, the extent to which the dramatic widening of spreads reflected a temporary drying up of liquidity as opposed to the extent it reflected fundamentals. This is a question of balance, since both sets of factors clearly played a role. Related to that is the question of whether emerging markets have taken a permanent hit. It is uncertain whether their potential economic growth rate has slowed or whether they are likely to return to previous levels after suffering a temporary hit. Such questions have an important bearing on emerging market debt’s likely fortunes as an asset class.
It makes sense to outline the uncontentious narrative first before trying to unpick what is still open to debate.
Unfolding of the pandemic
When Tedros Adhanom Ghebreyesus, the director-general of the World Health Organization (WHO), officially declared COVID-19 as a pandemic on 11 March, it did not appear to be primarily an emerging market phenomenon. Admittedly, the disease started to spread from China and by the time of the WHO declaration there were reportedly 118,000 cases in 114 countries. But within three days, Europe was declared the epicentre of the pandemic. A few weeks after that the focus shifted to the US. It was only in late May when Latin America was declared as the centre of the pandemic. And it is more recently still that some other emerging economies, such as India and South Africa, have recorded among the highest COVID-19 death tolls.
Yet emerging markets had already taken a huge financial hit from late February onwards. No doubt this was partly in anticipation of the direct harm likely to be caused by the disease itself. But, as the Bank for International Settlements (BIS) noted in its Annual Economic Report published in June: “Emerging market economies faced a perfect storm. In addition to the health toll, they had to deal with the losses in activity from domestic containment measures, plummeting foreign demand, collapsing commodity prices and a sudden stop in capital flows.”
In other words, emerging markets did not just take one hit, from the direct health impact of the virus itself, but blows from multiple channels. Indeed, the BIS schema could be divided further. For example, the slump in the developed world hit emerging economies in numerous ways. Not only was there a collapse in demand for goods but tourism revenue plummeted, as did remittances from migrant workers abroad. Commodity producers were hit particularly hard, with demand for raw materials also plummeting.
The broader picture is vital to understand but the focus here is on the changing financial conditions. In its initial stages the emerging markets suffered what the BIS and others referred to as a ‘sudden stop’ in capital flows. Capital not only ceased flowing into emerging markets but in many cases it started moving in the opposite direction. According to figures from the Institute of International Finance, a global association of financial institutions, there was a record-breaking $83.3bn (€70.6bn) of portfolio outflows from emerging markets in March. Of these, $52.4bn were in equity and $31.0bn in debt.
This sudden stop was the backdrop to the extreme pain that hit emerging financial markets. In addition to capital outflows, there was a sharp depreciation of emerging market currencies. Many had to go to multilateral institutions, such as the International Monetary Fund (IMF), for assistance. As a recent IMF study noted: “The COVID-19 pandemic has greatly lengthened the list of emerging market economies in debt distress. For some, a crisis is imminent. For many more, only exceptionally low global interest rates may be delaying a reckoning.” (‘The debt pandemic’, Finance & Development, September 2020).
However, in the financial markets at least, the situation has improved considerably since the dark days of March. Spreads have narrowed considerably. Capital flows have reversed. And to a large extent confidence has returned.
No doubt, emerging markets benefited from the decisive action by the Federal Reserve and other developed world central banks. The injection of huge amounts of liquidity into the markets helped shore up emerging markets too. In addition, although central banks in emerging economies typically have more limited resources, they also took action to ease conditions.
Nevertheless, a lot remains uncertain. It is always easier to describe developments than to discern the forces underlying them. The best that can be done with any confidence at present is probably to outline some of the key points of contention.
In most cases, the differences involved are matters of emphasis rather than absolutes. But emerging market debt is an area where relatively small differences of interpretation can have big practical consequences.
Liquidity versus fundamentals
The key question is probably whether the dramatic widening of spreads in March was driven more by deteriorating fundamentals or to interruptions in liquidity flows. There is a case to be made for both, since there certainly was a drying up of liquidity while at the same time the emerging economies took a severe hit (figure 2).
For Bob Noyen, the CIO of Record Currency Management, the sharp sell-off in March was mainly the result of a drying up of liquidity. He described what happened as “a seizing up of the global financial economy”. Investors were desperately trying to sell assets to raise liquidity but there were few buyers at that point . “The market became completely dysfunctional,” he says. Indeed, at the worse point there was, in his view, no market for practical purposes. The market could not do its job of matching buyers and sellers.
Cathy Hepworth, the head of emerging market debt at PGIM Fixed Income, also emphasises the importance of the liquidity shock but, in addition, points to the extreme levels of uncertainty at the time. This applied to the outlook for developed markets as well as emerging ones.
However, she does point out that with the fiscal deterioration and worsening debt dynamics there were rational reasons for spreads to widen. “The issue was whether they should have widened as much as they did,” she says.
However, Hepworth certainly accepts that financial market failures played an important role. “It underscored how large the buy side had become, relative to the capacity of the sell side to deal with it.”
A related question is the scale of capital outflows from emerging markets at the time. They certainly amounted to tens of billions of dollars at the time but there is some debate about what this means in the scheme of things. High frequency data, such as that tracking exchange-traded funds or retail fund flows, suggest extreme volatility. However, some argue that such data gives a misleading impression.
Steve Cook, co-head of emerging markets fixed income for PineBridge Investments, says that such figures only give a partial view. That is because the easy-to-measure figures fail to capture long-term holdings in the markets by the likes of long-term institutional investors and sovereign wealth funds. “Capital outflows tend to get overblown in terms of the amount of money moving in and out of the asset class,” he says. “There is still an obsession with retail mutual-driven fund outflows.”
Of course, institutional investors did not pile into emerging markets in March. But the total universe of emerging markets assets is much larger than that accounted for retail mutual funds or high frequency trading. Indeed, a lot of entities do not even publish their emerging market holdings, so the exact size of the universe is unclear. Cook argues that if such factors are taken into account it becomes clear that “emerging markets are simply not as volatile as a lot of people perceive”.
In any case, there is no doubt that huge injections of liquidity by central banks and other sources helped to stabilise the markets. This was led by the Fed, which saw a huge increase in its balance sheet (figure 3). Other central banks, including the European Central Bank (ECB) and the Bank of Japan, also played an important role.
Of course, none of these central banks has a direct mandate to assist emerging markets. But the simple act of pumping such huge amounts of liquidity in the market helped to ease conditions for everyone. In some cases there were also direct links between developed market and emerging market central banks. For example, the Fed announced temporary swap lines to several foreign central banks, including those of Brazil, Mexico and South Korea. These are countries that, among other things, are clearly of high strategic importance to the US.
Less noticed by the markets was the assistance provided by multilateral institutions to many emerging markets. “Such institutions also playing big role in helping emerging market economies,” says Federico Kaune, head of emerging markets fixed income at UBS Asset Management.
The difficult question is whether liquidity provided by international institutions has simply provided a temporary boost. It could be that many face several debt problems in the future. On the other hand, if the crisis was primarily one of liquidity, then the future looks brighter.
However, even some financial market institutions concede that, to some extent at least, emerging markets could have taken a permanent hit. For example, a report by JP Morgan says that “the pandemic will have done permanent damage to EM potential growth” (‘EM as an asset class in the post-pandemic world’, September 2020). Although output will bounce back to a certain extent in the coming year, it is likely, the study says, that policymakers will find it increasingly difficult to address rising debt burdens. This is despite the fact that interest rates remain relatively low.
However, the report also identifies what could be called a counter-tendency to the weakening of emerging market growth. That is, the global low-yield environment could increase the relative appeal of emerging markets to western investors in search of yield. In JP Morgan’s terms the ‘pull’ factors may be declining, with lower long-term economic growth, but at the same time the ‘push’ factors could rise as a result of low global interest rates.
Breaking down the universe
So far, this article has looked at the emerging market debt universe in general but it can, of course, be sub-divided in different ways. For example, different countries and regions have different characteristics. There are also the standard divisions between sovereign and corporate; investment grade and high yield; local currency and hard currency.
Perhaps the most important general point to be made, which applies to all these sub-asset classes, is that the easy gains have been made. It is clear, with the benefit of hindsight, that those who invested in March have generally done well. “The low-hanging fruit for emerging markets is gone,” says Kaune of UBS.
He also takes the view that, after all the turmoil, investment-grade debt is probably fairly priced. “We are basically where we should be in investment grade”, he says.
It was arguably the case that, in general terms, local currency debt offered more value. This was because emerging market currencies took a while to recover from the March turmoil. But they, too, seem to have recently reverted to levels that are closer to normal.
In country terms, Argentina has agreed a debt restructuring, although this would probably have happened without the COVID pandemic. The recent crisis has more likely accelerated the process. Many other smaller countries have either restructured their debt or are doing so.
More generally, PGIM Fixed Income has produced useful research identifying the vulnerability of 25 large emerging economies, according to different measures or what it calls “lenses” (‘The prospects for emerging markets – looking beyond the storm’. July 2020). These include vulnerability to the virus itself, economic vulnerabilities before the virus hit, sensitivity to a global downturn and the policy response. In aggregate terms, it places Brazil as the most vulnerable emerging market, followed by South Africa and then Romania. The least vulnerable country was South Korea, followed by Vietnam and then Thailand (see table).
Clearly there are important differences within the emerging markets universe but, overall, there remains a reasonable case for the asset class. Although they have undoubtedly suffered a heavy hit they are likely to grow faster, and offer higher yield, than what is available in developed markets. “Any sensible institutional investment portfolio that needs to deliver real returns at a 20 to 30-year horizon will have to have a certain proportion allocated to EM assets,” says Record’s Bob Noyen.
On the hand, the story could be completely different if the capacity of the authorities to shore up global financial markets is ever seriously called into question. If that happens, the events of this March could end up looking tame in comparison.
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