The macro environment in 2023 is likely to remain challenging for emerging market debt, especially in the first half of the year. Yet the headwinds to the asset class – inflation, monetary tightening, zero Covid Chinese policies and soft growth – are likely to stabilize and subside as the year advances. The decline in global macro risks will eventually create a supportive environment for performance of fixed income assets, including emerging market debt.
Headwinds are well priced
The headwinds to EMD are well priced and if / when the Fed does eventually pivot to a focus on supporting the US economy through a slowdown, emerging markets should perform well. We think however that could be in the latter rather than first half of 2023, or even 2024.
The focus is now shifting to the slowdown in global and particularly US growth, especially in the first half of 2023. There are clear indications that the US is now slowing, Europe is already likely in recession and China remains a wildcard around policy easing and the government’s willingness to persist with Covid restrictions. Political risk will also remain persistent.
Uncertainty surrounding whether China may choose to finally exit zero-Covid also clouds the outlook for next year. Expectations are low, but a reversal of those policies could provide a significant upside risk for growth and commodities in 2023, were it to occur.
EM growth will likely also be under pressure in 2023 but should outperform that of developed markets. EM inflation is likely to peak early next year and has already in several economies with rates markets in EM similarly sensitive to DM of any sign a roiling over of inflation providing ample opportunity for differentiating among countries in local rates markets. We retain a constructive commodities outlook for 2023 although we expect decline from the unprecedented highs of 2022.
Sovereign defaults are likely to persist in 2023, but the market is pricing more defaults than we think are likely to occur and most of the countries with elevated credit risk are already trading at extremely distressed levels.
Valuations offer good entry points
Global bond markets were hit hard in 2022 and EM was no exception with the largest drawdown on record. That was in large part due to the selloff in US rates, which also experienced its largest drawdown on record. That has left an asset class that, while with risks, is now offering extremely attractive valuations and a significant buffer against rising yields. Outside of the depths of the 2008 financial crisis, carry for EM sovereign credit is at its highest levels in two decades.
Attractive expected returns
On a one-year horizon, we expect EMD HC sovereign and LC to return around 11-15% with a baseline of 13%. The forecast assumes stabilizing US Treasuries amidst a US slowdown and some EM spread compression. We expect 5 and 10Y US Treasuries in a 3-3.5% range with a central scenario of 3.25%. Sovereign EM spreads are likely to tighten by 25-50bps and EM Currencies are expected to contribute 3-5%.
On a one-year horizon, we expect EM corporate gross return of 10-15% assuming 25-50bps lower EM corporate spreads and 5Y US Treasuries at a 2.75-3.25% range and given asset class carry of 7.6%.[1]
The main risks and opportunities for each EMD sub-asset class will be driven by the evolution of US Treasuries, the Chinese economy, and level of defaults for EMD HC and by EM disinflation, the trajectory of US Dollar, and by the EM versus DM growth differential for EMD LC.
[1] The scenarios presented are an estimate of future performance based on evidence from the past on how the value of this investment varies, and/or current market conditions and are not an exact indicator
