Emerging markets, battered by food and energy crises and rising debt levels, were front and center at the recent IMF-World Bank meetings. This group of nations is often lumped together as a homogenous block, but can we discern more nuanced investment and capital flow opportunities among the risks?
Let’s consider the external factors that do affect all emerging markets, starting with US dollar strength, and how it exacerbates the key risks.
The first is imported inflation, especially for commodity-importing countries. The cost of imported food and energy products, priced in US dollars, has created enormous fiscal strain and lifted the overall price level for large swathes of emerging markets. For those countries struggling to access hard currency, this problem becomes a crisis.
The second risk is that servicing US dollar-denominated debt has become a financing crisis for many emerging market borrowers at sovereign level, and for corporate credit market borrowers in those countries.
This means emerging market central banks have a decision to make: Do they intervene to smooth the depreciation of their currencies, and in doing so, risk a material decline of their Reserve Adequacy ratios? Or do they let the currency weaken with market forces and risk greater inflation, and then raise rates even more aggressively to control inflation but risk a material decline in growth?
Then we have the global tightening cycle. In addition to the most aggressive rate hiking cycle in several decades, the impact of QT (quantitative tightening) is starting to be felt. The annualized pace of balance sheet movement for the Federal Reserve, European Central Bank and Bank of Japan has now moved to contraction in year-on-year percentage terms. This has historically been a very strong warning signal for strangled global liquidity conditions, especially in emerging markets.
Finally, we have the risk of oil heading back above US$100 in light of recent production cuts from OPEC+. This will obviously ramp up the challenge for many energy importers and exacerbate the food crisis because of transportation, feed and fertilizer costs.
At the same time, we have a range of domestic factors to consider.
Borrowing, in the form of debt issuance such as bonds, increased significantly across both emerging and developed markets during the initial COVID pandemic, which meant that Debt/GDP ratios rose materially. Improving growth in the recovery saw this ratio fall, but ongoing challenges including the invasion of Ukraine and the surge in food and energy prices mean that many emerging countries have little fiscal ability to increase subsidies to support domestic populations, which in turn means declining ability to service their existing debts.
Worse, with growth now slowing, Debt/GDP ratios are rising again. This is all taking place against the backdrop of a challenging technical market in a variety of non-emerging market sovereigns, as we’ve seen played out publicly with UK government debt, for example.
This puts many countries in the difficult position of having to choose between debt servicing or feeding their people and, as we’ve seen at IMF-World Bank, this tension between tackling global inflation and the potential likelihood of sovereign debt restructurings is a huge subject of debate.
Having painted a very bleak picture, are there relative value opportunities for investors in global debt markets that can in turn benefit some or all emerging markets?
Trade is one area that inspires optimism. While global trade – for example, the main Asia to U.S. and Europe flows - is losing momentum, we have seen a significant pick-up in trade between emerging market countries, continuing a positive trend that has been growing over the last six years.
By some estimates, ‘EM to EM’ trade is nearly 50% of global trade now, up from just above 40% ten years ago. This seems to be strong evidence of the increasing importance of regional trade channels.
At the moment, ASEAN (The Association of Southeast Asian Nations) is benefiting the most from this, but we believe this trend should help many emerging market countries over the next three-to-five years.
There are also increasing signs of differentiation in economic growth across the universe of nations broadly referred to as ‘emerging’.
The ASEAN region and India are significantly outperforming North Asia in terms of growth. While North Asia is significantly more exposed to slowing global trade, India, Singapore, Indonesia and Malaysia currently all have good growth stories.
If we double click on India, it will be one of the top economies of Asia for the next two years. Domestic investment and infrastructure spending will help drive the economy and, while the country’s currency is weak against the US dollar, it is still outperforming many regional peers thanks to a strong foreign exchange reserve position.
Saudi Arabia and the United Arab Emirates (UAE) are dramatically outperforming their regional peers, with the former potentially posting the fastest growth of all in 2022. Latin America (LATAM), meanwhile, benefits from its central banks having been among the first movers to hike rates to tackle inflation. As a result, LATAM countries are significantly outperforming their global emerging market peers.
As we head into the next phase of this ‘polycrisis’, navigating emerging markets will continue to require a forensic appreciation of where capital can best be deployed.
Roberto Hoornweg joined Standard Chartered Bank as Global Head, Financial Markets in January 2017. The business serves to provide Standard Chartered’s clients with markets related services including Foreign Exchange, Rates, Credit, Commodities and Capital Markets. He is a member of the Corporate, Commercial & Institutional Banking Management Team and is based in London.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.