Emerging Market Debt (EMD) Views—Q1 2021

    Franklin Templeton Fixed Income

    2020 has been an unprecedented year for emerging markets. The drawdown emerging market debt experienced during March and April has largely been reversed, with positive year-to-date (YTD) returns firmly tilted toward higher quality credits. Since the trough, hard currency EM asset prices have been supported by inflows into the asset class and a recovery of commodity prices. Inflows have accelerated post US elections, along with optimism from positive COVID-19 vaccine news and have now returned to positive territory for the year. Flows into local currency, however, have lagged and remain firmly negative YTD.

    The impact of COVID-19 on EM sovereign balance sheets has been unquestionably negative and fiscal balances have deteriorated this year for every country in our investment universe, without exception. Though we hesitate to over generalize given the breadth of outcomes within our universe, the good news is that EM balance sheets have deteriorated at a less-rapid pace than for countries in the developed world. This is, in part, because developing countries have run lower fiscal deficits in 2020 and because EM countries have had more favorable gross domestic product (GDP) growth outcomes vis à vis their developed market counterparts. Our base case is that the recent balance sheet deterioration will not become a systemic issue for EMD. In relation to this year, what we generally see is that COVID-19 related fiscal expansions have been highest for those EM countries with the most fiscal breathing space. Many of the weaker countries have also taken the opportunity in recent years to term out their debt stocks, significantly reducing rollover risk on average, while debt servicing capacity has simultaneously increased as a result of the lower global yield environment. With longer tenure of debt, sovereigns have greater capacity to withstand periodic spikes in risk premia with little in the way of passthrough to debt servicing costs. However, we acknowledge that medium-term risks may present themselves if corrective fiscal measures are not ultimately taken and debt continues to accumulate.

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    EM fundamentals have deteriorated since the onset of the COVID-19 pandemic, although we acknowledge that these may improve somewhat into next year, from a weak starting point. We maintain a constructive view on the asset class over the next three, six and 12 months, as technical support for EMs remains strong, which is likely to offset the negative impact of worsened fundamentals. We believe spread levels should continue to attract inflows in an environment of low to negative yields, loose global liquidity and where investors remain structurally underweight emerging markets. With global liquidity conditions as supportive as they are, we see plenty of space for further tightening in EMD, with spreads remaining significantly above pre-COVID-19 tights.

    The impact of the US election has so far been positive, like it has for most risk asset classes, and appears mainly based on the clearing of a potential hurdle for financial markets rather than any specific emerging market factor. The prospect for greater regulation and restrictions on financial markets plus higher spending pushing up Treasury yields appears to be in check for the time being given the lack of full control of the Senate by Democrats. Even in the event Democrats win both seats in the upcoming runoff in the state of Georgia, their majority would be slim and deciding votes likely dependent on moderate Democrats. However, it is still too early to draw many firm conclusions on future policy given the priority of tackling the current COVID-19 epidemic. Longer term, the primary questions in regard to EMD about the next four years under President-elect Biden are on bilateral relations with China and energy policy. Although it is difficult to ascertain how relations with China will take shape at this point, it is fair to assume that negotiations will be less bombastic than under the outgoing administration, which should eliminate some of the risk premium from the uncertainty of the current Sino-US framework and will be a marginal positive for EMD. On energy policy, the potential for a rapprochement with Iran may offset stricter regulation on unconventional production and therefore should not have a significant impact, although EM producers may benefit if they avoid any stricter form of regulation versus US producers. The positive alignment for EMD from greater fiscal stimulus is that the asset class is geared toward global economic growth, which would benefit from a stronger US consumer. The positive correlation to US domestic risk assets would also add some follow-through to EMD asset prices.

    However, the high-quality segment of EM, with a long duration profile and relatively low spreads and yields, has the potential to exhibit weakness in the event that US Treasury yields were to defy the current central bank guidance of rates remaining low for the foreseeable future.

    We do not see the fiscal impact of COVID-19 itself as creating a systematic risk for emerging market debt. COVID-19- related fiscal expansion has generally been largest for those credits with greatest fiscal space and balance sheet deterioration in EMs has been less severe than for advanced economies. We believe that EM countries generally also have increased capacity for debt accumulation, as many of the weaker credits have termed out liabilities in recent years. Rather, we see the financing environment for sovereigns as being the more significant short-term driver of performance differentiation.

    Indeed, in the post quantitative easing “search-for-yield" world, many countries have been able to do considerable damage to balance sheets with very little in the way of flow through to borrowing costs or damage to market access. With liquidity taps running at full flow, the buildup of debt-related vulnerabilities had been largely considered by the market to be “tomorrow’s problem” given the ease with which even weak credits could access finance. Fast forward to 2020 and we have been operating in a vastly different financing environment, with US dollar market access at best not guaranteed, a dynamic that is more noticeably affecting higher-yielding countries. A more constrained financing situation, alongside the genuine humanitarian need for looser fiscal balances, has been a catalyst for considerable variation in financing strategy between sovereigns this year. Generically, countries with access to domestic bond markets have utilized these to borrow to fund fiscal overruns, to a much greater proportional extent than we have observed in past years. The fiscal cost of this increase in borrowing has been generally contained as EM central banks have thus far had sufficient space to lower policy rates with little in the way of passthrough to inflation or much indigestion in local bond markets.

    In some cases, lower policy rates have also been accompanied by financial repression—the dynamic by which governments are able to forcibly channel private sector liquidity into public sector lending. Such a policy comes with moral hazard risks from a fiscal perspective and clearly risks a “crowding out” of private sector. But in 2020, with weak private sector credit growth, financial repression has been enacted with reasonably low pitfalls in the short term.

    Given the breadth of credibility among EM institutions and varied adoption of such policies, we are employing a case- by-case approach to monitoring the medium-term risks posed using financial repression and artificially suppressed yields in EM local markets. We have a clear fundamental preference toward countries that have access to local funding mechanisms, where this clearly reduces short-term rollover risk—and indeed, the market has rewarded these countries this year. On the other hand, we acknowledge that long-term financial repression for countries with sizable local debt burdens can increase systemic macro risks and have knock on effects into the real economy. It is for countries without access to deep domestic local markets, or sovereign wealth, that we have seen the most bifurcation this year with respect to financing strategy as well as bond performance.

    The real game-changer for countries that have typically relied on external markets has been the shift in market willingness to fund credits with weaker credit metrics. For HY sovereigns, external market access in 2020 has been at best, expensive and size limited, prompting the need for a “Plan B” or even a “Plan C” for many of these countries. Sovereigns that entered 2020 with the largest unfunded short-term rollover needs have exhibited the highest degree of spread volatility. The alternative paths taken by weaker credits with unmet financing needs this year serve as a very good reminder of the importance of politics and geopolitics as drivers of country spreads in EMs. Out of the HY countries in our core universe, roughly 70% have been able to finance additional fiscal needs or overcome short-term rollover hurdles by accessing concessional financing and/or by agreeing moratoriums with official creditors. Intuitively, these countries have significantly outperformed HY peers without access to debt relief or concessional financing.

    Into 2021, we remain acutely focused on rollover dynamics for the most vulnerable sovereigns and prefer countries where political dynamics help ensure contingency financing access. All other things being equal, we also prefer sovereigns where fiscal consolidation will be supported by an improvement in the global growth environment, relative to countries that may require politically costly expenditure rationalization. Longer term, we see a risk that persistent use of less orthodox financing measures may spill over into sovereign risk-premia, and we continue to carefully watch the way individual sovereigns exit this paradigm.


    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. Municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. The price and yield of a MBS will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. A MBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of a MBS or in a MBS’s credit rating may affect its value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.

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