BlueBay’s Polina Kurdyavko and Anthony Kettle explore some key factors as Covid-19 reveals emerging market vulnerabilities – and resilience
Many investors are hoping that higher yielding - and relatively risky - assets such as emerging market debt could help in their search for yield, as part of a diversified portfolio.
But periodic crises over the last decades have given emerging markets a mixed record - with returns often driven by the precise timing of the investment across the market cycle, or by orientations towards a benchmark or a specific sub-asset such as foreign currency, sovereign debt, or corporate credit.
Wider world
Polina Kurdyavko and Anthony Kettle are tasked with building a view of emerging markets that is wide and deep. They use BlueBay's extensive team of sovereign, corporate, and local currency specialists to bring together a mosaic of insights across the key sub-assets and issuers, so they can manage their emerging market unconstrained bond strategy dynamically through the emerging market cycle.
The team say the initial shock of Covid-19 - emerging markets suffered unprecedented capital outflows last March - gave way to positive surprises. "The first surprise was the ability of many emerging market authorities to conduct a degree of quantitative easing (QE) and, more broadly, to otherwise conduct quite an orthodox policy mix in an environment of great uncertainty," says Kurdyavko.
The lack of inflationary fears going into the crisis meant that, "when you saw the Covid pandemic at its worst, with a lot of FX weakness coming through, central banks in emerging markets were still able to cut rates and stimulate that way," says Kettle. With luck, emerging markets will retain that new flexibility.
There remains a chance that over-enthusiastic QE might fuel inflation or erode debt sustainability. But Kurdyavko, who started covering emerging markets in 1998, is hopeful that 2020's response indicates "emerging markets have come a long way in terms of the maturity of the policy framework and their ability to use key levers to cope with a crisis."
Flexible FX
She thinks it is easy to overlook the impact of long-term structural changes. "For me, the biggest shift, particularly over the last 10 years, is the majority of emerging market countries moving towards a flexible exchange policy," she says, "which means currencies can take the brunt of adjustments - helping to avoid boom/bust scenarios."
"While we have seen increasing post-Covid levels of debt, we don't think this is yet at prohibitive levels for a lot of emerging market economies," she says, "and local currency markets have become the dominant source of funding for both corporates and sovereigns, reducing the FX liability that you have with hard currency debt."
Policy performance
However, there were multiple sovereign defaults and debt reprofilings in 2020 and the team acknowledge that there are considerable uncertainties. The IMF has described the prospects for many emerging market economies excluding China as ‘precarious',(1) and defaults might yet rise significantly if recovery scenarios harden due, for example, to a rockier than expected vaccine roll out, fears of inflation, or policy mis-steps.
"For me the key single determining factor in the performance of emerging markets in 2021 may come down to the policy mix in individual countries," Kurdyavko says, including "the ability of emerging market countries to manage their fiscal deficits in the lower long-term growth environment likely through 2021 and beyond."
"That's where this crisis differs: in prior crises, we exited the crisis with less debt and more growth," she says, "and this time, we're going to exit with more debt and a very uncertain growth outlook." Emerging markets generally relevered balance sheets a lot less than the developed world during 2020, she says, but leverage needs to remain appropriate.
Meanwhile, global growth will no longer help to cover up problems such as unorthodox policy, corruption and governance issues. "In a low growth world, we may see more inter-regional or international disputes because everyone has to find someone else to blame," she says.
- IMF, World Economic Outlook: A long and difficult ascent, October 2020, p.11
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