The Worst Is Likely Behind for Emerging Markets

After withstanding a multitude of global challenges last year, emerging markets look poised for improvement as inflation recedes and the path of monetary policy comes into view.

Despite a confluence of unprecedented shocks, emerging markets (EM) have shown resilience, with few signs of a broad-based crisis. As an asset class, EM appears to be positioned for stronger performance.

High EM real – or inflation-adjusted – rates buffer the spillover risks from further U.S. Federal Reserve (Fed) interest rate hikes and the effects of the strong U.S. dollar. China’s economic reopening provides a tailwind, and the peaks in inflation and fiscal pressures appear to have passed.

Structural forces such as deepening local markets and nearshoring support EM fundamentals. The magnitude of last year’s EM fund outflows suggests the asset class is now both structurally and cyclically under-owned, while EM valuations screen as historically cheap, in our view.

As a result, we are becoming increasingly positive on EM more broadly and select EM local debt in particular. Still, we remain cautious until the outlook for monetary policy becomes clearer, as much depends on the Fed’s ability to tame inflation and China’s ability to reactivate economic activity.

EM is resilient to the downside, and central banks have done their jobs

Pretty much everything that could go wrong for EM did in 2022, with pandemic pressures exacerbated by the war in Ukraine, the Fed rapidly hiking rates, high energy and food prices, China’s zero-COVID policy, the rise of populist regimes, and idiosyncratic climate problems.

Yet the majority of EM countries have recovered to pre-pandemic GDP levels. Leverage in EM has remained in check, with debt broadly stable relative to GDP (see Figure 1).

Figure 1 is a chart showing three lines, each representing a different measure of the ratio of emerging market (excluding China) general government (GG) debt to GDP, moving left to right across the years 1995 through 2023. The bottom line represents EM GG external debt to GDP, which starts about 20% in the late 1990s, declines closer to 10% around 2007, and levels off in recent years around 15%. The middle line shows GG domestic debt to GDP, starting just above 20% and gradually rising above 30% while leveling off in recent years. The top line represents total GG debt to GDP, combining the data in the other lines.

That resiliency is likely to continue in 2023. EM benefitted from proactive central banks that – unlike in previous episodes – prioritized controlling inflation over growth and did so earlier than developed market (DM) peers, raising real rates well above neutral levels.

As a result, while headline inflation is still high, the peak looks to be behind us (for more, see our November blog post, “Peak Inflation May Hint at Peak Rates in Emerging Markets”), with EM core inflation more in line with DM trends. Looking forward, the signal from high market-implied real rates in EM is that EM policymakers are likely to remain vigilant. This should keep inflation expectations anchored and below inflation targets into 2024.

Today, EM borrows overwhelmingly in local currency and with longer-dated debt than ever before (see Figure 2). This, together with the growth of institutional EM savings, helps minimize external refinancing risks and the impact of rising U.S. rates on borrowing costs and debt sustainability.

Figure 2 is a chart showing three lines moving left to right from 2009 through 2022. The bottom line measures the duration of EM local bonds in years, starting at about 4.5 in 2009 and rising to about 7 in 2022. The line representing weighted average maturity of EM bonds starts at about 6 and rises to 10. The line representing foreign ownership of EM local bonds starts at about 19% in 2009 and falls to just under 16% in 2022.

Structural features are becoming cyclically relevant and supportive

EM external balances are predominantly financed by foreign direct investment (FDI) flows. These tend to be more stable than the volatile portfolio flows in the post-2008 global financial crisis (GFC) era of quantitative easing by global central banks. FDI flows are being driven by longer-term forces that have accelerated, such as nearshoring into countries like Mexico, the need for energy independence in DM, and climate-related investments in EM.

Lower external imbalances – in the form of fewer overvalued currency pegs and lower external leverage – offer an additional buffer, enabling EM foreign exchange to be a release valve from Fed cycle spillovers.

Furthermore, EM corporations have entered this rising rate environment with strong balance sheets after record levels of refinancing and liability management in recent years. The EM corporate default rate – excluding Russia, Ukraine, and the outsize impact of the China property sector – was just 1.8% in 2022, according to JPMorgan, broadly in line with DM.

EM set to benefit from China reopening

Since the GFC, China has taken over from the U.S. and Europe as the main driver of EM growth (see Figure 3), as China has evolved from an end user of commodities, to a cog in global production, to a consumer of EM goods and services such as tourism.

EM growth has thus far been resilient in spite of China’s slowing. A successful China reopening would disproportionately benefit EM, even if demand shifts from commodities to services in this cycle.

Figure 3 is a bar chart measuring EM growth sensitivity to changes in GDP in the U.S., China, and the euro area both before and after the global financial crisis (GFC). It shows the percentage point (ppt) response of EM GDP to a 1-ppt change in U.S. GDP has fallen from more than 7 ppts pre-GFC to just over 1 ppt post-GFC. For China, the gauge rises from just over 1 ppt pre-GFC to about 4.5 ppts post-GFC, and for the euro area it falls from just over 3 ppts to about 2.5 ppts.

With Chinese growth rising 5%–5.5% year-over-year in 2023 in PIMCO’s base case, EM will likely remain resilient even in the event of a DM recession (which we expect would be mild – for more, see our latest Cyclical Outlook, “Strained Markets, Strong Bonds”).

Our baseline is for EM growth to slow to 3.5%, from 5.5% as the DM economic slowdown bites and EM output gaps close. Yet this does not fully reflect benefits from China’s reopening, which we expect to take hold in the first half of 2023 and accelerate in the second half.

Value is back in fixed income and EM is underinvested

The repricing in 2022 has restored value in EM, with yields rising to pre-GFC levels. By several metrics, EM valuations look cheap (see Figure 4), and historically EM returns have been in the high single digits at similar yields.

Figure 4 is a bar chart showing average 12-month forward historical total returns at current yield ranges for global investment grade (IG) debt (3.18%), U.S. IG (4.81%), U.S. high yield (6.63%), EM local (6.79%), and EM external (10.46%).

The technical backdrop has also improved. Last year saw the largest-ever annual outflow from EM funds – about $89 billion across external and local debt, according to JPMorgan, which is close to 16% of the asset class – resulting in a sharp cyclical underinvestment into EM.

If the decade-long supercycle of U.S. dollar strength (see Figure 5) finally ends, it could also attract inflows into EM local debt from investors who want to express a short-dollar view.

Figure 5 is a line chart showing U.S. dollar supercycles based on in index gauge of real exchange rates from 1971 through 2021. It shows a peak in 1971, a trough in about 1977, a peak in 1985, another trough in the late 1980s and early 1990s, a lower peak in 2002, troughs in 2007 and 2011, and the line rising to another peak in 2021.

Challenges necessitate focus on downside protection

Geopolitics and internal politics will remain drivers of policies and market perceptions of EM. The war in Ukraine remains a key source of uncertainty, with questions about Russia’s energy leverage as Europe gets better prepared on gas supplies. Markets will continue to digest the implications of recent elections in countries such as Brazil, but the 2023 election calendar in EM is relatively light, with Turkey and Argentina being the notable exceptions.

Frontier markets appear vulnerable, with some countries locked out of capital markets. The sovereign default rate for this subset of EM is moving higher, with several countries likely to restructure their debt over the next few years.

A focus on the potential downside, and having systematic frameworks for navigating these risks, is therefore imperative. (For more on PIMCO’s risk framework in EM, see our blog post, “Spotting Opportunities and Risks Across the EM Investment Universe.”)

We would caution against being tempted by low-quality EM credits trading at high yields, and would instead focus on the investment grade and BB portion of the asset class, which offers a lower risk profile and where forced sales have created value.

We think the worst is likely behind for EM, with investors likely to find improved opportunities across the EM landscape this year. Specifically, we currently favor EM local assets in markets with high real rates such as Brazil; corporate credit in commodity-exporting countries; select EM financials; and currency long positions in countries such as Thailand that we believe are well positioned for the upside in China.

To learn more, visit PIMCO’s Emerging Markets site.

The Author

Pramol Dhawan

Portfolio Manager

Lupin Rahman

Portfolio Manager



PIMCO Australia Pty Ltd
ABN 54 084 280 508
AFS Licence 246862
Level 19, 5 Martin Place
Sydney, NSW 2000

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