We see improving outlook for credit in general due to overwhelming policy action to limit the coronavirus shock and recent market selloffs. Yet we have turned more cautious on emerging market (EM) local debt despite depressed valuations after selloffs. Why? Currency is key. Some emerging economies have allowed their currencies to weaken to help absorb the economic shock. We see a risk of further currency declines in some emerging economies, and this could wipe out the relatively high coupon income from local debt. There are brighter spots in EM: We are still overweight equities and credit in Asia outside Japan, with China gradually restarting its economy and readying more policy support.
Emerging economies are different in economic fundamentals, fiscal conditions, governing capabilities – and the quality of public health systems. Compare key metrics on our interactive Emerging markets marker. Many EM currencies have fallen sharply against the U.S. dollar, such as the South African rand and Brazilian real. See the chart above. This follows a pattern seen in past crises, when countries with the greatest external vulnerabilities (current account deficits) have often taken the biggest hit to their currencies’ exchange rates. One difference from previous crisis periods: Many emerging economies today are not fighting currency declines, which act as economic relief valves that can increase export competitiveness and shrink current account deficits over time. Instead, they are easing monetary and fiscal policies. This comes with risks. Potential capital flight could exacerbate currency declines and force some EM central banks to reverse course and raise rates.
It is not all bad news for emerging markets. We see the Federal Reserve’s recent flurry of emergency policy actions – as well as those of other major central banks – as supportive of fixed income markets globally. The Fed’s moves aim to ease financial conditions and provide ample U.S. dollar liquidity. Among them: cutting interest rates to near zero, purchasing investment grade and high yield bonds, and providing dollar liquidity to more foreign central banks via dollar swap lines. We see the liquidity in developed markets spilling over to the EM world. As yields compress in DM credit, many investors will likely seek out alternative sources of coupon income such as higher-quality EM debt. Another potential positive: China is gradually restarting its economy after stringent lockdown measures and is set to deliver a large stimulus package. A rebound in China’s economic activity could bode well for EM exporters of bulk commodities in particular.
Yet we worry about the ability of many emerging economies to weather a growth shock that is set to exceed that of the global financial crisis in magnitude. EM activity was the first to plummet, led by China. Economists now see growth modestly contracting in the EM world for 2020, with risks skewed to the downside. The coronavirus outbreak threatens to overburden weak public health systems in many emerging economies, leading to the prospect of prolonged economic damage. International lenders of last resort such as the International Monetary Fund have signaled a willingness to step in aggressively to aid EMs in financial distress. This will help plug significant funding gaps and liquidity shortages, but such help typically comes with strings attached such as potential debt write-downs.
The bottom line
We downgrade EM local debt to neutral given risks of further currency depreciation and keep hard-currency EM at neutral. Overall, we see a place for income sources such as EM debt in a world where yield is hard to come by, but favor global investment grade and high yield credit at this point. We remain neutral on EM equities, as outperformance is more contingent on a growth recovery than it is in credit. We overweight Asia ex-Japan equities, which we see leading such a recovery as China slowly reopens its economy. We generally prefer credit over equities given bondholders’ preferential claim on corporate cash flows in a highly uncertain economic environment.