There were record-breaking investor outflows from emerging markets debt in 2022 and 2023. So far, 2024 hasn’t seen much of that capital rushing back.
A peak and decline in US interest rates has typically been a favourable backdrop for the asset class, however, and it is only a matter of time before investors turn their spotlight back onto its attractive inflation and growth dynamics, strong corporate fundamentals and notable turnaround stories.
Inflation and growth
Inflation has declined substantially across all regions and now sits broadly within local central banks’ comfort zones (Figure 1). We expect further disinflation from here to be more modest, with some lingering risk in oil prices and shipping costs. Overall, however, attractive real yields – especially in Latin America, where we saw some of the world’s most aggressive hiking cycles – and a bias towards policy easing, are likely to support local-currency bond performance.
Following a dip in 2021 and 2022, we have also seen emerging economies’ growth differential over developed economies rebound to its longer-term average of around two percentage points (Figure 2). As China has struggled to regain traction, India has emerged as a key growth engine and looks likely to record four consecutive years of expansion in excess of 7%. This is driven by strong public capital expenditure, measures to boost local manufacturing and a boom in service sector exports.
We believe the emerging markets growth advantage can persist if the soft-landing scenario continues to play out in the US. Combined with the high carry resulting from those aggressive emerging markets rate hikes, this fundamental strength should support local currencies.
Figure 1. Strong inflation and growth fundamentals in emerging markets
Headline inflation, year on year, %
Source: Bloomberg, EMD team forecasts from 4Q23, as of 3 April 2024. EM aggregate includes China, India, South Korea, Taiwan, Singapore, Indonesia, Malaysia, Philippines, Thailand, Czech Republic, Hungary, Poland, Romania, South Africa, Turkey, Brazil, Mexico, Colombia, Chile and Peru. Regional aggregates are equally weighted averages of corresponding countries. For illustrative and discussion purposes only.
Figure 2. Emerging markets’ growth differential has rebounded
Manufacturing purchasing managers’ index, emerging markets minus developed markets
Source: Neuberger Berman, Markit. PMI data as of 30 June 2024. For illustrative and discussion purposes only.
Default risk receding
This outlook also bodes well for defaults, in our view. We see limited risk of sovereign defaults this year, as the more vulnerable countries have managed to secure new funding (Figure 3). More concerted engagement with the International Monetary Fund should result in support for funding needs and reform agendas.
Argentina is pursuing ambitious fiscal reforms and just recorded its first budget surplus since 2012. Egypt has secured valuable capital inflows from Gulf countries, the European Union and the World Bank, while extending its IMF reform programme. Nigeria has undergone a currency devaluation and a hiking cycle, and is pursuing tax and subsidy reforms that should improve its budget position. Sri Lanka continues a steady recovery from its multi-year economic crisis, with a debt restructuring due to be finalised this year, an IMF programme and a rebound in income from tourism and remittances. Zambia has just exited from default status after three and a half years and Ghana has obtained its bondholders’ preliminary approval for a restructuring.
We believe default risk is receding for high-yield corporate issuers, too: our forecast is for the rate to fall to 4.8% this year, down from 7.8% in 2023 (Figure 4). Excluding the China property sector, which is likely to remain the main source of corporate defaults this year, our expected default rate drops to 3.3%, which is lower than the historical average. Risks from a slowdown in earnings are mitigated by strong corporate balance sheets on average, with liquidity buffers near decade highs and debt ratios lower, on average, than those of US companies, following years of deleveraging.
Figure 3. Emerging market default risk is receding
Emerging markets sovereign default rate, % of notional
Source: Neuberger Berman estimates as of 31 March 2024. For illustrative and discussion purposes only.
Figure 4. Default risk also receding for high-yield corporate issuers
Emerging markets high yield corporate default rate, % of notional
|
2022 |
2023 | 2024 (estimate) |
2011-20 average |
|
| Asia |
16.5 |
8.0 | 5.6 |
4.3 |
| Central and eastern Europe, the Middle East and Africa |
16.1 |
10.0 | 3.4 |
2.2 |
| Latin America |
3.7 |
5.3 | 1.7 |
4.3 |
| Total EM |
14.0 |
7.8 | 4.8 |
4.6 |
| Total EM, excluding China real estate |
8.3 |
5.0 |
3.3 |
Source: Neuberger Berman estimates as of 31 March 2024. For illustrative and discussion purposes only.
Value still available
Is this benign outlook for the asset class already in the price? We do not believe so. While valuations have become relatively expensive in parts of the investment-grade hard-currency market, we continue to see opportunities for spread compression across numerous higher-yielding names and, outside of Asia, attractive carry in local-currency bonds and foreign exchange. A reversal of the past two years’ outflows could be the catalyst for that spread compression.
The key risks, in our view, are the potential for a re-acceleration of global inflation and a consequent hawkish turn by central banks, and a return to a more aggressive protectionism in the US following the election in November.
Kaan Nazli is Senior Economist and Portfolio Manager for Emerging Markets Debt and Jahangir Aka is Head of Official Institutions and Managing Director, Neuberger Berman.
This material is provided for informational and educational purposes only and nothing herein constitutes investment, legal, accounting or tax advice.
These themes will be discussed in more detail at Neuberger Berman’s Global Fixed Income Webinar on Thursday 25 July. Register to attend here.
