Emerging Market Era Faces More Headwinds After Rough Start

The Mexican and Chilean pesos appreciated 7% or more in the past three months, and Hungary’s forint also rallied

A currency exchange shop in Santiago, Chile,
April 02, 2023 | 01:48 PM

Bloomberg — A turbulent end of the easy-money era has deflated expectations for a boom year for battered emerging-market assets.

Brought down to earth by a volatile first quarter, the much-hyped EM investment story for 2023 is turning into one of resilience and hopes for decent returns — that is if fundamentals, not contagion risk, drive flows.

A turn-of-year rally, spurred by odds of a less-aggressive Federal Reserve and Chinese growth, soon turned tenuous as global banking turmoil shook investor confidence. Those jitters caused developing stocks to pare an early gain, ending the quarter up just 3.5% — about half the return of developed-market peers. EM dollar debt gained 1.7%, less than other global fixed-income segments.

But even modest upticks “in a world where the developed markets are massively trying to slow demand” highlight a degree of resilience after a dismal 2022, said Steven Quattry, a money manager at Morgan Stanley Investment Management.


“If I told you over a year ago that the Fed rate would be near 5%, the dollar has strengthened, and EM is still hanging in there, you might have been surprised,” New York-based Quattry said. In January, his firm hailed the start of a decade of EM outperformance, taking money out of US stocks to snap up riskier assets at attractive valuations.


Last year, EM dollar debt handed investors losses of 15% and stocks declined 22%, the worst showing since 2008. The 2023 early comeback was interrupted by tremors in the global financial system.

Despite this hiccup, and potential further bouts of instability as the world grows accustomed to higher borrowing costs, EM fundamentals remain appealing: a superior growth outlook, an expected inflation decline and China’s reopening from Covid restrictions.

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“There are still attractive premiums — but whether that means EM will outperform developed-market fixed-income markets, it’s very difficult to say,” said Liam Spillane, head of emerging-market debt at Aviva Investors Global Services Ltd. “However, we do believe EM fundamentals look relatively strong compared to developed markets.”

A net $40.9 billion flowed into global EM equity funds through March 29, the most in a year, with Chinese funds accounting for nearly a quarter of that, according to EPFR Global data. Bond funds, meanwhile, saw net withdrawals of $1.6 billion in the period, following a $13 billion exodus in the last three months of 2022.

Quality Matters

High-yield EM debt suffered from a flight to quality in global markets. The extra yield investors demand to hold speculative-grade sovereign bonds over US Treasuries has widened 62 basis points in the quarter, compared with a 19 basis-point increase for investment-grade bonds, according to JPMorgan Chase & Co. data.

That’s taken the gap between the two — a spread of spreads — to 732 basis points, or more than two times the average from the past 20 years. That’s fueling questions whether junk bonds are relatively oversold and due for a spell of outperformance.

Flight to Safety | Higher-rated bonds yield best returns among developing-nation peersdfd

Wall Street is split. Aviva’s Spillane said higher-quality debt in the investment-grade universe will help drive total returns, while Jean-Charles Sambor, head of EM fixed income at BNP Paribas Asset Management, is betting on high-yield and frontier names.

“Every time there has been such a big dislocation of high yield versus investment grade, it’s always normalized. This time around should be no exception,” said Sambor. “You already had massive outflows last year, so it’s hard to have more outflows when people are still very underweight and valuations are much more appealing in EM.”

AllianceBernstein Ltd., meanwhile, warns the stress building up in frontier markets will linger and recommends reducing holdings in riskier EM segments.


“It’s very difficult to get optimistic before we reach the trough in the global economic cycle,” said Adriaan du Toit, London-based director of EM economic research at the firm. “Nations that don’t have the institutional framework that can counterbalance some of these social risks could lead to more credit deterioration.”

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Emerging Modesty

Resilience has also been clear in local government debt, which has returned about 3% this year, and currencies. The Mexican and Chilean pesos appreciated 7% or more in the past three months, and Hungary’s forint also rallied.

If financial instability curbs appetite for further interest-rate hikes in the US, it could weaken the dollar and support EM currencies, Gramercy Funds Management LLC, chaired by Mohamed el-Erian, said in a report published last week.

The report reflects a humbler investment outlook after Gramercy, in October, stressed that avoiding developing markets would be a “non-recoverable mistake.” Now it acknowledges that “no one ever said removing the punch bowl would come without challenges.”


While there will be more “pain” as the world exits an ultra-low rate environment, there are reasons to stay cautiously optimistic, said Claudia Calich, the head of emerging-market debt at M&G Investments.

“The market is very sensitive in terms of figuring out what is next,” she said. “We’re still in deeply data watching mode, both in terms of economic activity but also inflation.”

What to Watch

  • Brazil’s fiscal framework proposal will be in focus for investors, who cautiously welcomed the plan immediately after its release.
  • Traders will watch Turkish inflation data for signs of a slight deceleration.
  • The National Bank of Poland is expected to keep the key rate at 6.75% despite stubborn inflation.
  • Pakistan’s central bank is seen raising borrowing costs amid the push for an International Monetary Fund bailout.
  • India’s central bank will also announce its key rate. While most economists see a 25-basis-point hike, Bloomberg Economics expect the policymakers to hold steady.
  • The Central Bank of Sri Lanka will likely keep its key rates on hold.
  • In Chile, the central bank may hold its rate at 11.25%.

--With assistance from Srinivasan Sivabalan and Kenneth Hughes

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