As noted in previous articles, a number of fears are raising concerns about future emerging market (EM) sovereign debt yields amid interest rate hikes by the US Federal Reserve (Fed).
Having considered two such fears – the possibility that the sensitivity of emerging market debt to rising interest rates could hurt performance and the possibility that emerging market debt spreads could widen as interest rate hikes are hurting global growth – we now look at three other fears.
Could outflows accelerate as fixed income and risky assets become less attractive? Could the US dollar (USD) strengthen as interest rate differentials between emerging and developed markets narrow? And could rate hikes reduce liquidity and accelerate emerging market debt restructurings?
Could capital outflows accelerate as fixed income and risky assets become less attractive?
The perception persists that as rates rise, fixed income investments, especially those with longer durations, become less attractive. This, according to common wisdom, leads to a cycle of exits and underperformance.
It is difficult to draw conclusions about the first two cycles of rate hikes, as the data is unreliable. However, during the 2015-2018 rate hike cycle, inflows were strong. Assets under management relative to emerging market hard currency benchmarks actually rose about 20% on strong inflows without any period of appreciable negative drawdown. Assets then grew another 10% in the year following the first rate hike (2016).
Our verdict: although flows are currently down, they should improve. This is supported by a 2021 International Monetary Fund (IMF) paper concluding that growth optimism is not a key driver of hard currency bond flows. These flows, according to the paper, have historically been more sensitive to global risk sentiment. Moreover, one of these factors is not necessarily decisive for the other.
In recent years, flows to dedicated hard-currency bond funds from emerging markets have been positive despite headwinds related to COVID-19. This year was the exception. In 2022, we have already seen reasonably sized net outflows as global liquidity conditions have tightened. These were quite persistent but decreased in size at the beginning of May.
The outflows we’ve seen so far this year have revalued hard-currency assets in emerging markets well ahead of those in other credit markets, leading to lighter positioning by dedicated investors (who now hold balances very high cash flow) and cross-investors. Average bond prices in the JP Morgan EMBIGD benchmark are now around $85, below their COVID-19 lows recorded in 2020.
We expect that as valuations continue to improve, flows will return to the asset class, which could act as a catalyst for higher prices.
Could the USD strengthen as interest rate differentials between emerging and developed markets narrow?
The fourth fear driving concerns about future emerging market sovereign debt yields is that the USD could strengthen as interest rate spreads between emerging and developed markets narrow.
Conventional wisdom holds that the ongoing Fed tightening cycle amplifies USD strength, and with the USD trading persistently, it is certainly understandable that investors are concerned about the role of the USD. in driving asset price returns.
However, USD strength has not been a key historical driver of EM debt spreads. On the contrary, the strength of the USD has a slightly positive correlation with the tightening of spreads.
Looking back to previous Fed tightening cycles, little information is available on the impact of rising US interest rates on USD strength and the subsequent impact on emerging market sovereign debt spreads.
1999-2000: strong USD. During the 1999-2000 rate hike cycle, the USD strengthened, but this was mainly due to speculation that the Euro would crash soon after its launch.
2004-2006: Weak USD. The 2004-2006 rate hike cycle, meanwhile, was a period of weakness for the dollar against the euro, given concerns about the US trade deficit and investor attention shifting to data. monthly sales. During this period, it was difficult to detect a positive impact on the USD from the rate hike cycle.
2015-2018: Mixed USD. In the first part of the 2015-2019 rate hike cycle, currency volatility was quite low and the USD strong – until European Central Bank (ECB) President Mario Draghi delivered his speech in March 2017, which reversed the euro crisis and set the price of the euro sharply higher against the dollar.
Our verdict is that it is too early to tell. But investors worried that the strong USD will be bad for EM debt spreads can take comfort in the possibility of it weakening. As we entered the 2022 rate hike cycle, the USD was already overvalued, with one-sided positioning, as seen in the chart below.
Could rate hikes reduce liquidity and accelerate emerging market debt restructurings?
The fifth fear driving concern about future EM sovereign debt yields is that rate hikes, and a subsequent Fed balance sheet reduction, could reduce market access for investors in lower-quality EM debt. , causing an avalanche of defaults and restructurings. We believe this risk is already overpriced in the market, for a number of reasons.
First, multilateral and bilateral support for economically distressed emerging markets is extremely high, with the IMF alone providing around $250 billion in support. And that’s only a quarter of the IMF’s $1 trillion available lending capacity.
Second, outside of 2020, when EM sovereigns experienced a relatively high level of restructurings, historical EM debt defaults and restructurings have been extremely low. This has been true even in previous cycles of Fed rate hikes, which did not cause a glut of defaults. Additionally, when restructuring was required, salvage values averaged 55 cents on the dollar, a level well above that of corporate bonds.
We have seen a move away from bonds trading at a price of 100 or more at the end of 2021. JP Morgan’s EMBIGD is also more diversified in 2022 than it was in previous cycles of rising rates in the Fed, which reduces the concentration risk of a single default. .
 Source: Moody’s and JP Morgan, from December 2000 to December 2020; refers to the JP Morgan Next Generation Markets Index (NEXGEM).
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.