The nature of the economic landing will have direct implications not only for default rates but also for the valuation of all asset classes, as it will be influenced by discount factors. Additionally, 2024 is poised to be a year marked by political risks, driven by a series of sensitive elections and ongoing military conflicts across the globe.
In this outlook, we will dive into various factors that impact EM hard currency bonds, including fundamentals, technical indicators, and valuations. These factors are expected to exert a direct influence on the returns of EM fixed income investments.
By examining these key aspects, we aim to provide an overview of the opportunities and challenges that lie ahead in the EM Fixed Income space for the year 2024.
Market participants may witness fewer rate cuts than initially anticipated
The market is currently pricing in a soft landing with six rate cuts expected in 2024, while the Federal Reserve’s (Fed) projections indicate only three cuts We anticipate that the market may be disappointed, but it remains unclear whether this disappointment will be due to a hard landing or concerns about the pace of rate cuts.
Figure 1: FOMC participants’ assessments of appropriate monetary policy: Midpoint of target range or target level for the federal funds rate. Adapted from US Federal Reserve, Summary of Economic Projections, 2023.
In the absence of a recession or a significantly weak labour market, it is unlikely that we will see inflation drop below 2.5% or that the Fed will be implementing such a high number of rate cuts. While a reduction of 50-75 basis points could be justified to move towards a more neutral policy stance, the Fed will likely want to preserve some ammunition in case of a future recession and will also need to normalise its balance sheet (see Figure 2). Therefore, market participants may witness fewer rate cuts than initially anticipated.
Figure 2: Federal reserve balance sheet from 2000 to 2023. Sources: Bloomberg; US Federal Reserve, 2023
Considering that the effect of the monetary policy on the economy operates with a lag, there is a risk that economic growth could decelerate more than anticipated, potentially leading to a recession. In this scenario, investors may become concerned about debt sustainability, as both corporates and governments have become accustomed to a low-rate environment and may struggle to cope with higher refinancing rates. This could result in not only six or more rate cuts, but also higher spreads driven by increased default risk.
While the trajectory of interest rates remains uncertain and will depend on where inflation ultimately stabilises, we believe that the US dollar rate curve will steepen. If a recession is avoided and inflation stabilises at a higher level, we expect to begin normalising its balance sheet, which would lead to higher long-term rates. However, if a recession does occur, we may see even further rate cuts, mostly impacting the shorter end of the yield curve, while the longer end is kept elevated due to increased issuance and concerns about debt sustainability.
Markets have demonstrated a greater ability to adapt to the new monetary policy regime
It is noteworthy that despite the rapid and substantial hiking cycle, market liquidity remains robust. This is evident from our liquidity indicators, which measure funding stress in the global financial system, including swap-spreads that gauge liquidity risk. Neither of these indicators signal any significant concerns or stress.
One possible explanation for this phenomenon is that the markets have demonstrated a greater ability to adapt to the new monetary policy regime than initially anticipated. By already pricing in rate cuts for 2024, the market has effectively mitigated a portion of the impact from the Federal Reserve’s rate hikes.
If this is indeed the case, it raises questions about the effectiveness of monetary policy in addressing cyclical inflation. There appears to be a disconnect between the expected slowdown in inflation driven by monetary policy and the absence of funding stress. Monitoring liquidity levels could prove to be a valuable indicator in assessing whether inflation is likely to stabilise at higher levels or if a recession is looming on the horizon.
Emerging markets positioned for growth
We anticipate that EM countries will outperform developed market (DM) countries in terms of growth. This is primarily due to the greater flexibility that EM countries have in terms of both monetary and fiscal support.
One key distinction between EM and DM countries lies in the composition of their consumer price inflation baskets, particularly the importance of food prices. While DM inflation slowdown may be constrained by elevated wage growth and a tight labour market, the decrease in inflation resulting from lower food prices in EM countries appears to be more sustainable. This provides EM central banks with greater leeway to ease monetary policy if necessary.
On the fiscal side, EM countries have traditionally managed debt sustainability concerns better than their DM counterparts. According to the International Monetary Fund’s World Economic Outlook Database from October 2023, the gross debt of G7 countries is projected to reach 128% of GDP by the end of 2023, while it is expected to be around 67% for EM and developing economies. Although there is considerable variation within these numbers, on average, EM countries have more room for their governments to support their economies. For instance, China is expected to implement a significant fiscal deficit to bolster its economy and combat deflation, which is likely to have a global impact within the region.
Overall, the combination of greater monetary policy flexibility and relatively healthier fiscal positions EM countries favourably for potential growth compared to DM countries.
Focus on high-quality issuers
While credit spreads may appear tight from a historical perspective, the attractiveness of the bond yields cannot be overlooked, particularly given their reduced exposure to economic cycles. The yield of EM corporate bonds of around 7% (as of 2 January 2024) compares well to the long-term average return of equities, which varies between 6.5-7%[1].
The breakeven level is particularly appealing. With a duration of approximately 4.30, the CEMBI yield would need to widen by more than 160 basis points (bps) in 2024 for the mark-to-market performance to offset the carry. Even if the Fed disappoints and cuts rates by only 75 bps instead of 150 bps, this will result in a 75-bps widening on the shorter end, which would still be within the breakeven range.
In the event of a recession, we may see spreads widen by more than 160 bps, but the risk-free rate would move in the opposite direction. By focusing on high-quality issuers, we can increase our exposure to the risk-free rate and optimise our expected risk-adjusted return in our main scenarios.
More local currency issuances expected
On the supply side, the market is expected to see stable gross issuance in 2024, following the low levels seen in 2023. The negative net financing and limited availability of bonds should support market prices, as benchmark investors will need to reinvest coupon payments and maturing bonds to avoid becoming underweight.
Unlike in 2022 and 2023, where the lack of issuance was driven by challenging market conditions, we anticipate that companies will issue more in local currency this year. With the rise in USD rates, there is less incentive for companies to raise debt on the international market, and they are likely to prefer their local options.
Bottom-up selection remains critical
We anticipate significant dispersion in 2024, which will create opportunities for active portfolio managers to generate alpha. We believe that issuers with excessive leverage will likely underperform due to the increased cost of funding. As higher rate starts to bite, companies that have relied on cheap funding to enhance profitability may face challenges in the coming year.
Given the multiple elections and conflicts happening around the world, we expect the market to incorporate a considerable amount of political risk. Unlike the leverage cycle, political risk premiums are mostly idiosyncratic in nature and can be diversified. While they need to be assessed on a case-by-case basis, they can provide attractive entry points as non-specialists exit the market.
Considering our expectation for the interest curve to steepen, along with the risk of a recession, we favor investment-grade securities and the shorter end of the yield curve. These segments still offer attractive carry characteristics. With strong expectations for a soft landing, there is room for disappointment, and we see no need to take unnecessary risks.
Conclusion: Hard or soft landing?
This year, the focus of the beta market call will be on determining the type of landing we can expect. Will it be a hard landing, leading to a recession, higher spreads, and significant cuts from the Fed? Or will it be a soft landing? In this scenario, where will US inflation stabilise, and what will be the consequences for the Fed?
To assess the probabilities between these two scenarios, we will closely monitor financial market liquidity, which serves as a good indicator of the impact of monetary policy tightening on the real economy.
Additionally, we anticipate that EM hard currency bonds will outperform other asset classes this year. We believe that these bonds will be supported by strong technical factors as well as robust fundamentals.
Lastly, we expect that while the past two years have been primarily driven by beta, the majority of financial outperformance will come from relative value trades. Geopolitical risks, as well as the distinction between winners and losers in this new market environment, should generate the dispersion required for active portfolio managers to outperform.
[1] Jeremy J. Siegel, Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies, fifth edition, New York, NY: McGraw-Hill Education, 2014.
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