The prevailing view seems to be that global financial conditions will deteriorate when the Fed hikes rates and therefore vulnerable emerging markets will struggle to refinance their external debt. This pessimism has resulted in an aggressive sell-off of emerging market hard-currency sovereign debt at the start of 2022 as bond markets repriced on expectations of more front-loaded Fed hikes and quantitative tightening. Therefore, rather than actual Fed hikes, it is the market’s repricing in anticipation of the implementation of Fed policy that has caused turbulence in EM debt amid fears of excessive tightening of global financial conditions. If we look at the last three Fed hiking cycles, between 99-2000, 2004-06, and 2015-18, EM spreads and EM yields were declining, and EM sovereign performance was quite decent. This shows that EM spreads tend to widen ahead of the Fed’s hiking cycles, only to gradually tighten during the hiking cycle itself. Right now, we are probably at peak market pessimism on emerging markets.
Countries that absolutely need market access to roll over their debt and that currently have yields in the high-single digits or close to 10% in US dollars are naturally the most exposed to tighter global financial conditions because they could lose market access and would have to resort to alternative sources of external financing to remain current on their external debt repayments. Egypt is an example, which is why it has been a relatively poor performer in the last few months. Yet, Egypt obtained syndicated loans from Gulf banks for 3 billion US dollar and a bilateral loan from South Korea for 1 billion US dollar, which is enough to cover its external financing needs for at least six months and stay out of the conventional Eurobond market during the first half of 2022. Other vulnerable countries include Ghana, which has already lost market access and is now trying to regain market confidence by committing to achieving its fiscal consolidation targets this year. Ghana’s strength is that it does not have significant short-term debt maturities and that it has a comfortable level of international reserves, so it does not have to tap Eurobond markets through 2022.
On the other side of the spectrum, investment grade countries are unlikely to face problems issuing external debt, but at current prices those are the bonds that are more likely to lose value in 2022 given how low their spreads are when compared to US treasury yields. Meanwhile, HY issuers have a large spread cushion and are likely to deliver significant positive returns later this year, according to our estimates.
Default risks remain low
There are only a few countries at risk of short-term default or restructuring in 2022. The reason is simple. Countries (and corporates) usually restructure their debt at the beginning of a crisis, and a few did so in 2020, because this is when their revenues are at their lowest point and the need to support their economy is the greatest. We are not at the early stage of a crisis anymore, we are in the late stage of a strong recovery, so for most countries it doesn’t make any sense to restructure anymore. Of course, there are exceptions. Sri Lanka and Ethiopia are two examples of countries that are likely to restructure in 2022, but in both cases bond prices already fully price in the restructuring. In fact, current bonds prices are likely below the recovery value in both cases, which means that, in our view, investors are unlikely to face losses on these bonds.