We remain generally constructive on emerging market fixed income assets, reflecting a view that the asset class will benefit from global growth recovery, capital flows, stable US Treasury yields, and a weaker US dollar. The global abundance of liquidity, relatively attractive valuations compared to low and negative yielding debt from developed markets, and growth differentials will be important drivers of EM asset class performance. We expect emerging market economies to benefit from improving economic performance in developed markets and China. Given trade and capital linkages, a strong rebound in consumption, and strong manufacturing PMIs in combination with worldwide input-shortages are all supportive for emerging economies provided they can respond quickly to rising demand.
Global trade has rebounded in 2021 to above pre-crisis volume levels, reflecting the strength of the recovery. China was the first country where the economic revival got under way, and with being a very large user of raw materials demand for commodities recovered rapidly. With the global economic activity trending upwards, supported by the progress of vaccination programs, pent-up demand, fueled by accumulated savings and postponed investment, the external positions for emerging market commodity producers should strengthen. However, further improvement in global economic activity is highly dependent on the evolution of the pandemic. Covid-19 related uncertainty is far from gone, but improved vaccination rates in developed and emerging markets means the impact of newly emerging variants is likely to be less severe.
The accommodative monetary stance has been a tailwind to the asset class over the past two years. However, as easing measures are likely being curtailed, with US Federal Reserve (Fed) tapering looming on the horizon and several central banks in the emerging economies having to respond to closing their output-gap and rising inflation, emerging markets will face rising debt and refinancing costs. EM investors concerned about a repeat of the 2013 Taper Tantrum remain reassured by the Fed’s view that factors within recent inflation prints are likely to prove transitory. Notably, that comes in the context of a recent trends in inflation observed in the United States. Unlike China with external sovereign debt primarily in domestic currency, other emerging economies have sizeable external debt and/or foreign investors that own a sizeable share of domestic debt. Elevated debt levels across the universe will therefore require monetary and fiscal discipline, and some countries are likely to seek debt forgiveness under the G20 Debt Service Suspension Initiative (DSSI) Common Framework. Additionally, the International Monetary Fund (IMF) US$650 Special Drawing Rights (SDR) will provide additional liquidity, thus supplementing countries’ foreign exchange reserves and reducing their reliance on more expensive domestic or external debt.
Within EM, we observe a divergence in the speed of economic recovery with Latin America and African countries clearly lagging emerging Asia. Once the remnants of the pandemic have been dealt with, which in certain emerging economies might take longer, they may experience a decelerating trend in GDP growth, signs of which we observed already before the outbreak of the Covid-19. New Covid-19 cases continue to rise in EM economies led by the delta variant. So far, this hasn’t proven a major concern, however, the outlook for 2021-2022 is contingent on levels of immunity and vaccine rollouts. Under the World Health Organization COVAX initiative, vaccines are being made available in developing economies, with richer countries subsidising costs for poorer nations.
Emerging market debt spreads have, on balance, seen a compression since the summer last year, with 2021 bringing a flattening to a level around historical averages. Given the strong recovery in economic activity we expect a decent excess return over developed market sovereigns in the next four years. Higher global commodity prices and food prices will likely add pressure to inflation and hasten monetary policy normalization in emerging markets. Going forward, the trajectory of Covid-19 cases, evidenced by the spread of the delta variant, the improving global growth outlook, and US Treasury yields, will remain central to our asset class outlook.