Outlook on
Emerging Markets
JUL 2021
Summary
• The pace of recovery globally has varied widely, but with
vaccinations trending higher and a restart for global capital
expenditures, we expect a stronger recovery in emerging
markets in the second half of this year.
• The return of inflation is a good sign for economic growth,
and therefore, good for emerging markets equities—
particularly those with the highest levels of operating
leverage. Our equities experts tend to think that core
inflation will follow the path of developed markets inflation
and push higher in the near term, but remain contained in
the medium term.
• Overall, our outlook for emerging markets debt is
constructive, and we believe the asset class is poised to deliver
strong absolute and risk-adjusted returns.
• In the current environment, we believe being selective—
among segments of the market and individual countries—will
be key to capturing these returns. We see compelling value in
three areas in particular: high yield hard currency sovereign
debt, corporates, and increasingly, local currencies.
Equity
In the second quarter, the MSCI Emerging Markets Index finished
up 5.05% in US dollar terms. From a regional perspective, Latin
America had a strong showing, driven by strong performance in Brazil,
followed by Europe, the Middle East, & Africa (EMEA) and Asia.
From a sector perspective, health care, energy, and industrials posted
double-digit returns, followed by materials and financials securities,
all of which outperformed the benchmark. Real estate, consumer
discretionary, communication services, and information technology
RD12136
lagged this quarter. While economically sensitive value securities, for
which we use the MSCI Emerging Markets Value Index as a proxy,
registered their third consecutive quarter of outperformance, growth
securities (measured by the MSCI Emerging Markets Growth Index)
posted strong gains in June.
In 2020, investors watched the COVID-19 pandemic materialize
and spread around the world. A year later, the recovery is doing the
same. The virus originated in China, and China was the first country
to lock down and bring it under control, which allowed the country
to also be the first to enter a recovery period. The United States now
appears to be in the thick of the recovery period after a relatively
successful vaccination campaign, and we expect that in retrospect,
the second quarter will represent a peak in US GDP growth. After a
slow start, Europe’s vaccination efforts are picking up, and we expect
peak quarterly growth there in the third quarter of 2021.
In emerging markets, the pace of recovery has varied widely. China,
Korea, and Taiwan all responded swiftly to control the initial
outbreak and have been essentially open for several quarters now.
(It’s worth noting that China has recently instituted lockdowns
again to control outbreaks, and we feel breakthrough outbreaks
will continue to happen.) However, India endured a brutal second
wave that overwhelmed the country’s healthcare systems as recently
as May 2021, and Latin America also continues to suffer mightily
in some areas. Though vaccination rates have started to trend up
in emerging markets, the rollout in the first half of the year was
slower than we had expected or hoped. One of the reasons for that
is that relatively little vaccine manufacturing occurs in emerging
2
markets. We expect the countries included in the asset class to begin
to recover in earnest in the second half of 2021 and continue into
2022, a more prolonged recovery than we would have suspected
three months ago.
The virus isn’t the only factor playing a role in the emerging
markets recovery. Rising commodity prices, buoyed in part by the
global economic recovery, represent a tailwind for some exporting
countries. Not only do rising prices bolster the performance of
commodity-producing companies, they also help reduce fiscal and
current account deficits in emerging markets economies. However,
as we will discuss, the impact of rising prices is complex for emerging
markets equities—not every emerging markets country benefits from
an inflationary environment.
Exhibit 1
The Value Proposition
Index (100 = 30 September 2020)
140
120
MSCI EM Value [LHS]
110
120
MSCI EM Growth [LHS]
100
100
Value Relative to Growth [RHS]
80
Oct
2020
Nov Dec
2020 2020
Jan
Feb Mar
2021 2021 2021
Apr
2021
May Jun
2021 2021
90
As of 30 June 2021
Source: MSCI
In terms of investing styles, value stocks, which tend to be in more
cyclical sectors, have so far reaped the greatest rewards from the global
reopening. The MSCI Emerging Markets Value Index returned 5.67%
in the second quarter, outperforming the MSCI Emerging Markets
Growth Index (+4.42%) for the third quarter in a row (Exhibit
1). Historically, market rotations from growth to value have been
dramatically positive for value stocks. After more than a decade of
underperforming growth stocks, we are hesitant to say just yet that
a value rotation is in fact underway, but we are getting closer to that
conclusion.
Corporations Reopen the Checkbook for Capex
It’s easy to write off the economic recovery in emerging markets as a
result of rising commodity prices, as most emerging markets countries
are net exporters of commodities, or of favorable base effects in
comparing growth to a year ago, in the thick of a pandemic. However,
with the expectation of an economic rebound, new infrastructure
programs, and an increasing focus on environmental sustainability,
capital expenditures could increase, particularly in the developed
world. In their role as suppliers to the developed world, an uptick
in capital spending in developed markets bodes well for emerging
markets. In the United States, capital spending is increasing by 15%1
year over year, as companies spend on both durable goods (e.g.,
machines and factories) and intangibles (e.g., software).
Forecasts for gross fixed capital formation are projected to be much
higher in 2021 than in 2020 in both the developed and emerging
world. The United States and euro area are expected to reach 8.0%
and 5.7% this year, respectively, and the figures vary widely across
emerging markets: Colombia, Argentina, and India are expecting 16%
to 21% gains; Hungary, Indonesia, Brazil, Chile, and Greece range
from 8% to 12%; South Africa, Korea, Mexico, Turkey, and Russia
have the lowest gains, from 1% to 7%; while fixed capital formation
will actually decline in Poland and the Czech Republic (Exhibit 2).
Exhibit 2
Most Countries Will See Capex Rise in 2021
2020
Poland
Czech Republic
South Africa
Mexico
Korea
Turkey
Euro
OECD
Russia
US
Hungary
Indonesia
Brazil
Chile
Greece
India
Argentina
Colombia
-30
2021
Poland
Czech Republic
South Africa
Mexico
Korea
Turkey
Euro
OECD
Russia
US
Hungary
Indonesia
Brazil
Chile
Greece
India
Argentina
Colombia
-9.6
-8.1
-17.5
-18.2
2.8
6.5
-8.5
-4.4
-4.3
-0.8
-7.3
-4.9
-0.6
-11.8
-0.7
-14.0
-13.0
-20.6
-20
-10
0
10
20
30
-30
-3.3
-2.4
1.6
3.5
3.6
5.6
5.7
5.9
6.6
8.0
8.3
8.4
8.6
9.3
11.5
16.3
18.2
20.6
-20
-10
0
10
20
30
Gross Fixed Capital Formation (YoY, %)
As of 31 May 2021
Source: Haver Analytics, OECD
3
From an industry perspective, global technology firms are leading
the capital spending charge. Apple is expected to invest $430 billion
in the United States over a five-year period. Taiwan Semiconductor
Manufacturing Company, the world’s largest semiconductor-maker,
recently announced that it would invest $100 billion over the next
three years to expand and upgrade its chip capacity. After having
already increased its capital spending by 45% in 2020, Samsung
Electronics is expected to bump up its spending plans this year.
Additionally, capital spending is expected to be higher for Korean
shipbuilders, particularly for the development of eco-friendly vessels
and expansion of low-carbon production facilities to meet stricter
environmental regulations.
Not all firms are increasing spending plans, however. For instance, many
oil and gas and raw materials companies continue to practice capital
discipline, even as commodity prices have moved significantly higher.
On the government side, plans for large-scale infrastructure
investment in the US and Europe are likely to be a major catalyst
for global economic growth, particularly in developed markets. It
is still unclear exactly what the scope of an infrastructure might
be in the United States, as Republicans and Democrats disagree
on what the priorities should be. But what does seem fairly safe to
assume is that a major spending bill that provides for upgrades to
roads and bridges, public transit, water and wastewater systems, and
other traditional infrastructure will pass in the coming months. If
US President Joseph Biden is successful in achieving his priorities,
there could also be added spending on a broader definition of
infrastructure projects, including electric vehicle production and
basic research. In the European Union, the €570 billion Next
Generation EU Project is gearing up to fund a slew of infrastructure
projects that vary by country, but include many projects focused
on sustainability and environmental objectives. This project should
in particular benefit the three Central European economies in the
MSCI EM Index (Czech Republic, Hungary, and Poland).
Aside from boosting overall economic growth, the spending in
developed markets should feed through to emerging markets mostly
in the form of higher demand for raw materials such as steel, copper,
and cement. HSBC noted in a recent report that developed economies
tend to use more recycled materials and perform repairs and upgrades,
which provide less of a boost to commodities than starting from
scratch with new materials, which tends to occur in emerging markets.
However, both plans have a much greater focus on environmental
priorities than in the past, which could bode well for minerals
associated with the batteries that store solar and wind power, as well
as those that power electric vehicles, including cobalt and lithium, as
well as the copper in the wiring that conducts the electricity. It’s also
worth noting that climate negotiations begin again in November, and
demand for green infrastructure should remain strong as countries
strive to make progress toward their emissions reductions pledges. All
in all, we believe infrastructure plans could provide a meaningful boost
to demand for raw materials, which would be a boon to emerging
markets equities.
The uptick in capital investment is particularly good for growthsensitive assets, as well as assets that benefit from higher commodities
prices. Though investment fell sharply at the start of the COVID19 pandemic, it has bounced back relatively quickly. The hope
for equities investors is that the nascent pick-up in global capital
spending persists long after most economies reopen, allowing for
faster global economic growth and higher productivity in this
recovery than the sluggish pace set in the years that followed the
global financial crisis. Given the position many emerging markets
companies hold in the global supply chain, a pick-up in capital
spending around the world is a very good signal for emerging
markets equities overall, particularly growth-sensitive stocks, names
that benefit from higher commodities prices, and those that produce
goods, rather than services.
Inflation: Here to Stay or Soon on Its Way?
Inflation has returned to the global economy. The United States
has experienced perhaps the most dramatic uptick in prices, with
headline consumer prices rising 5% for the 12 months ending in
May and the core inflation rate reaching 3.8%, the highest level since
1992. In emerging markets, inflation is also trending up, pushed by
a combination of pandemic-related uncertainty, supply bottlenecks
and logistical issues, and higher energy prices. Meanwhile, producer
prices are soaring in emerging markets, but so far, the feed-through to
consumer prices has been uneven (Exhibit 3).
Exhibit 3
Input Costs Are Soaring, but the Story Is More Complicated
for Consumer Prices
Producer Prices Moving Higher across EM
PPI (YoY, %)
40
Brazil
30
Chile
China
India
Mexico
Russia
20
10
0
-10
-20
Mar΄18
Sep ΄18
Mar ΄19
Sep ΄19
Mar ΄20
Sep ΄20
Mar ΄21
Consumer Prices Remain Wide-Ranging
CPI (YoY, %)
10
8
Brazil
Chile
China
India
Nov ΄18
May ΄19
Indonesia
Mexico
Russia
EM
6
4
2
0
-2
May ΄18
Nov ΄19
May ΄20
Nov ΄20
May ΄21
PPI data as of 31 May 2021 and 30 April for Brazil; CPI data as of 31 May and 30 April
for EM only
Source: Biro Pusat Statistik (Indonesia), Federal State Statistics Service (Russia),
Haver Analytics, Instituto Brasileiro de Geografia e Estatística (Brazil), Instituto
Nacional de Estadísticas (Chile), Instituto Nacional de Estadística Geografía e
Informática (Mexico), Ministry of Commerce and Industry (India), Ministry of Statistics
and Programme Implementation (India), National Bureau of Statistics of China
4
China is a good example of the forces at work. The producer price
index (PPI) rose 6.8% year over year in April and 9.0% in May, the
fastest pace in more than three years, thanks largely to a rebound
in commodities prices. Brent crude oil is nearing US$75 per barrel
and futures prices for iron ore, the main ingredient for making steel,
surged to almost US$230 a tonne in May, the highest level on record.
The rapid recovery in the Chinese economy has driven strong demand
for raw materials, including a construction boom that led to record
steel production of 1.1 billion tonnes in 2020. Chinese policy leaders
pledged to release government stockpiles of industrial metals to
address both the high prices and a shortage of iron ore. They have also
launched a review into “malicious speculation” in iron ore markets.
The intervention, plus the Federal Reserve’s somewhat hawkish
comments in June, pushed commodity prices lower, but even before
that, it was unclear to what degree rising commodity prices would
ultimately trickle down to the consumer. China’s consumer price
index (CPI) rose 0.9% in April and 1.5% in May, the highest level
in eight months, but was still well below the country’s 3% target.
However, a shortage of semiconductors has already begun to drive
up price increases for various consumer products, such as washing
machines and laptops (Exhibit 4).
The return of inflation is pushing a growing number of emerging
markets central banks to abandon the dovish policies of the COVID19 era and begin tightening monetary policy. In fact, the steady
announcements are reminiscent of the synchronized easing that took
place during the pandemic.
• The Central Bank of Brazil hiked rates 75 basis points (bps) three
times over the last three months and at its most recent meeting in
June indicated that it would likely raise rates another 75 bps at its
next meeting, which would put interest rates at 5%. The central
bank has said that if inflation expectations go much higher, they
could hike all the way to the neutral rate, which is about 6.25%.2
• Russia’s central bank raised its policy interest rate for the second
consecutive time in June to tame inflation, which is running
at its highest level in almost five years. The CPI rose to 6%
last month, well above the 4% inflation target and driven by a
Exhibit 4
China’s Rising Producer Prices Start to Feed into
Consumer Costs
(%)
10
CPI
5
0
PPI
-5
-10
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
As of 31 May 2021
Source: National Bureau of Statistics of China
sharp rise in global food and commodity prices. Price caps have
been implemented by some of Russia’s top retailers on some
key consumer staples, and the economy minister is considering
implementing export quotas or additional duties on food products
should global prices continue to push higher.
• Hungary became the first European nation to hike rates in June,
followed quickly by the Czech Republic. Though Hungary’s actual
increase was relatively small (0.3% to 0.9%), it was significant. It
was the first time the central bank had raised interest rates in 10
years, and officials explicitly noted that it was the beginning of a
hiking cycle that would end only when the country’s inflation rate,
the highest in Europe, reached a “sustainable level.”
• Banxico surprised investors with a rate hike in late June,
immediately touching off speculation about whether the increase
was a one-off response to a higher-than-expected inflation print or
the beginning of a hiking cycle.
We feel that the uptick in inflation, a signal of strong economic
growth, is generally a good thing for equities, especially in emerging
markets. The earnings outlook is particularly strong for companies
with the highest operating leverage, or those that stand to earn
greater profits as sales increase. Both prices and input costs rise in an
inflationary environment, but a high proportion of costs are fixed
for a company with high operating leverage, putting them in a better
position to maintain or increase profit levels as their revenues climb.
However, rising prices are not an unmitigated good. Our biggest
concern would be if inflation reaches a level so high that it impedes
global growth, which would be a clear negative for emerging markets
equities. Certain segments of the asset class are likely to feel pain even
in a less extreme inflationary environment. Reflation—which occurs
when prices rise because an economy is getting back to normal—can
lead to derating or contracting equity valuation multiples for companies
in certain rate-sensitive sectors. Growth stocks with extremely elevated
valuation multiples are often more vulnerable to this kind of negative
market reaction, particularly those in the healthcare, communication
services, consumer discretionary, and information technology sectors.
That’s because much of their earnings potential lies in the future, and
higher interest rates reduce the current value of those earnings.
All in all, we believe the best scenario would be one in which inflation
rises gradually to a level higher than what investors have become
accustomed to over the last 13 years, but fails to reach a level in
developed markets that holds back economic growth. Since the global
financial crisis, both economic growth and price increases have been
anemic, the latter a likely result of prolonged quantitative easing and
ultra-easy monetary policy. An environment of little-to-no inflation,
or even falling prices for certain commodities and other goods, has
been damaging for emerging markets, just as a hyperinflationary
environment would be.
As we weigh the pros and cons of the return of inflation, we also
weigh arguments that the current environment will prove fleeting
against those that it will endure. Those who believe inflation will
soon fade argue that it is a temporary artifact of the world coming
back online. During the pandemic, lockdowns and quarantine rules
shuttered or disrupted manufacturing in many areas; demand for
certain goods, particularly those that could be used in a new home-
5
centered lifestyle, such as exercise equipment or computers, rose; and
shipping demand overwhelmed ports and logistics companies, many
of which were also grappling with new pandemic safety measures that
decreased capacity. All of these things contributed to higher prices,
particularly on certain items.
Rising food prices are a major concern in emerging markets
economies. Global food prices have increased by the largest margin in
a decade, with the United Nations Food and Agriculture Organization
(UN FAO) Food Price Index rising 40% in May (Exhibit 5). The
higher inflation will disproportionately impact poorer countries that
rely on imports for staple goods. The cost of labor, transport, and
shipping will continue to pressure food prices in the coming months.
Rising food commodity prices reflect China’s large demand for grain
and soybeans; a severe drought in Brazil, which is a leading corn and
soybean exporter; and increased demand for vegetable oil for biodiesel.
Exhibit 5
Skyrocketing Food Prices Can Be Devastating for Poor
EM Countries
UN FAO Food Price Index (YoY, %)
45
30
15
0
-15
-30
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
As of 31 May 2021
Source: UN FAO
However, as lockdowns become less frequent and economies reopen,
bottlenecks on making and moving goods should ease, too. In addition,
many companies seem to have learned valuable lessons from COVID-19
and reported plans to bolster their supply chains for the future. Nearly
40% of large US companies surveyed recently by EY said they had plans
to make their supply chains more resilient in the coming year, with
nearly 20% saying they would diversify their suppliers.
We believe it is too early to pick a side in the debate about the staying
power of recent inflation. The temporary effect of reopening is hard
to parse out of the current numbers, and year-over-year prints still
compare today’s prices to a very low base from a more dire period
in the pandemic’s history. We tend to think that core inflation will
follow the path of developed markets inflation and push higher in
the near term, but remain contained in the medium term. Shocks to
current inflation drivers, including food and energy prices and output
gaps, are expected to be short-lived—an artifact of post-pandemic
readjustment. More importantly, we believe that pent-up demand,
help from government stimulus, and renewed capital expenditures all
support a multi-year period of high global growth. Should that come
to pass, it would be a very positive development for emerging markets
stocks, particularly since we think it is highly unlikely emerging
markets central banks will tighten aggressively.
Latin American Politics Simmers
Of the three major emerging markets regions, Latin America suffered
by far the worst human and economic toll from COVID-19. It
is not surprising, then, that a year after the pandemic reached the
region, a number of critically important political changes occurred
in Latin America in the second quarter. Mass protests broke out in
Colombia in April over a proposed tax increase, but even though the
proposal was scrapped, demonstrations have continued for about
two months, apparently fueled by anger over economic inequality.
Meanwhile, surprise election results in Peru and Mexico have
reshaped the political landscape.
Peru has had arguably the most dramatic political landscape in the
world over the past two years. Within a week in November 2020, the
country churned through three presidents. On 5 June, the country
elected its fourth president in a year, leftist Pedro Castillo. The result
was still not official as of 18 June, with Castillo’s opponent, Keiko
Fujimori, claiming that election irregularities had tainted the process
and the result. However, it seems likely that Castillo will become the
next president.
On the campaign trail, Castillo discussed plans to increase social
spending, raise taxes significantly on the mining sector, and possibly
even nationalize key industries. As the world’s second-largest copper
producer, any developments related to the mining sector and private
participation in it would be critical not only for Peru, but for the
world. However, Castillo and his economic advisors have been
reassuring markets that they do not plan to make radical changes,
talking down the risk of nationalization, and vowing to protect both
property rights and monetary policy independence. Another reason to
be optimistic about radical changes is that the Congress is divided, with
right-leaning parties controlling a clear majority of the votes. While
Castillo has yet to announce what he will actually do in office, we will
certainly be keeping a close eye on developments in the country.
The mood of the electorate seemed to go the opposite way in
Mexico, where the left-leaning coalition led by President Andrés
Manuel López Obrador lost its supermajority in the lower house
in the midterm elections. With a simple majority in both the
Senate and Chamber of Deputies, the President’s ruling MORENA
Party will still be able to approve some new laws and proposals.
López Obrador can also ask the public to vote on specific issues
to demonstrate to his opponents that he maintains strong public
support. As with a 2018 referendum to cancel the Mexico City
airport, these referendums would be non-binding.
The outcome means that López Obrador is likely to encounter
stronger checks on his power from parliament going forward, thereby
reducing his chances of passing constitutional reforms to further
his nationalist agenda, most notably in the energy sector. The prior
administration had awarded a number of permits to private-sector
companies to break up the state’s monopoly hold on power generation
in the country and revitalize Mexico’s power infrastructure, but López
Obrador had held up the permits and hoped to stop the privatization
bid entirely. López Obrador also had plans to reform the country’s
hydrocarbon law to give Pemex, the state-owned oil company, more
control over the domestic oil market. Previous administrations had
opened Mexico’s oil industry up to private investment, but the
6
reforms López Obrador wanted to pass would give Pemex the right to
suspend their permits and take over their facilities if there was a threat
to security or the economy.
The drop in popular support for MORENA suggests that the
president’s star may be waning three years after winning a landslide
election, which in turn increases the potential for fragmentation
among the governing coalition. We see this as a positive development,
as it has the potential to strengthen political checks and balances,
reduce policy uncertainty, and improve the investment outlook.
Meanwhile, good news about the progress of the pandemic finally
started to trickle out of Brazil, Latin America’s largest economy and
one of the hardest-hit by COVID-19. Vaccination efforts are finally
gathering steam: 27% of adults have at least one shot, while 11%
are fully vaccinated. While the Chinese CoronaVac vaccine accounts
for roughly half of the 80 million jabs already administered in the
country, most future vaccinations will be with mRNA and viral vector
vaccines. In the first quarter, before vaccinations ramped up in earnest,
GDP growth returned to pre-pandemic levels of 1.2%, so it seems
reasonable that second-quarter results could be even stronger. As the
vaccine rollout accelerates, we expect an improved recovery picture in
Brazil by the end of the year.
On the political front, President Jair Bolsonaro’s approval ratings
have stabilized and could improve as the national vaccine rollout
advances in the coming months and economic recovery gets underway
in earnest in the coming quarters. Next year’s presidential election
between Bolsonaro and former President Luiz Inácio Lula da Silva
looks to be a very polarizing and competitive election.
Emerging markets growth has lagged potential and developed markets
for much of the last decade and is expected to do so in 2021 as well.
The United States is projected to grow 6.5%–7.0% in 2021, the
highest rate in decades, thanks to extraordinary fiscal stimulus and a
swift COVID-19 vaccine rollout, taking growth preeminence among
all major economies except China.
Now, however, this backdrop is starting to turn: Emerging markets
growth is beginning to accelerate just as developed markets growth
expectations are starting to decelerate from abnormally high levels.
In fact, emerging markets growth is expected to take the lead in the
fourth quarter and continue leading in 2022, as the influence of
the developed world’s vast stimulus and swift vaccine rollout fade
and base comparisons become more difficult (Exhibit 6). Emerging
markets growth is already building steam thanks to strong external
demand and elevated commodity prices. Going forward, the factors
that have caused emerging markets growth to lag in 2021—struggles
in containing COVID-19 and delayed vaccine rollouts—are likely to
reverse. When that happens, we expect a further boost in growth from
pent-up demand as economies can more fully reopen.
Exhibit 6
Growth Differentials Are Shifting in Favor of Emerging Markets
GDP Forecasts (Seasonally Adjusted Annual Rate)
(QoQ, %)
10
Developed Markets
Debt
6
Emerging Markets Are Retaking the Lead
4
Emerging markets debt enjoyed smoother sailing in the second
quarter. US Treasury bond volatility declined, and the US dollar
weakened, allowing the blended hard and local currency emerging
markets debt asset class to earn a solid gain of around 4%. The asset
class almost fully retraced its loss from the first quarter, when it was
caught in a tug of war between the positive effect of better global
growth expectations and the negative effect of rising US interest rates,
with the latter winning out.
2
Although volatility picked up in the final weeks of the second quarter as
the Fed adopted a more hawkish tone, we see the pullback as transitory
and the factors driving our constructive outlook remain intact. It is not
often that top-down factors, bottom-up fundamentals, and valuations
align favorably, and we believe the asset class is poised to generate
attractive returns, both on an absolute basis and relative to other fixed
income sectors.
Accelerating Growth
First and foremost, the macro backdrop for emerging markets debt is
increasingly favorable. Emerging markets assets are levered to global
growth; specifically, growth differentials between the emerging and
developed worlds tend to be key performance drivers for the most
cyclically sensitive emerging markets assets, such as local currencies.
Emerging Markets
8
0
2Q21
3Q21
4Q21
1Q22
2Q22
As of 10 June 2021
Source: JPMorgan
We are encouraged by the trend of upward revisions to emerging
markets growth forecasts. The OECD now expects emerging markets
growth to be 4.5% above its pre-COVID level by the fourth quarter,
up from 1.6% in the December forecast (Exhibit 7). We think such
upward revisions will continue as the cyclical recovery takes hold
and emerging markets countries outperform low expectations. For
example, Brazil has struggled to control COVID-19, and political
turmoil has further weighed on the economy. However, the economic
data already show signs of improvement. First-quarter growth came
in at 1.2%, which was 0.7% above the consensus expectation. More
importantly, the outlook continues to improve. Prior to the first
quarter upside surprise, consensus expectations for 2021 had already
been revised upwards from 3% to 4%, and we think the Brazilian
economy could grow even faster if the country manages to accelerate
the pace of vaccinations. So far in June, Brazil has deployed an average
1 million shots per day, according to data compiled by Bloomberg—a
sharp increase from the 663,000 seen in May.
7
Exhibit 7
OECD Emerging Markets GDP Forecasts Revised Higher
GDP vs. Pre-COVID Levels
GDP Forecast (Index, 100=Q4 2019)
110
Current Forecast
105
100
December 2020 Forecast
95
90
2019-Q4
2020-Q2
2020-Q4
2021-Q2
2021-Q4
2022-Q2
2022-Q4
As of 1 June 2021
Source: OECD
The markets oscillated during the final weeks of the second quarter
as investors grappled with a shift in tone at the Fed. In our view,
the Fed will only begin to tighten policy once the economy shows
evidence of a sustained recovery and even then, will do so at a
gradual pace. The Fed has yet to even discuss the timing of tapering
its $120 billion per month bond purchase program, and the actual
implementation is unlikely before 2022. The fact is that financial
conditions are highly accommodative and are likely to remain so,
with the rate-hike cycle unlikely to kick off before 2023. In fact,
financial conditions in the United States are the easiest on record
(Exhibit 8). We are watching for any signs of tightening financial
conditions, which would likely have negative implications for
demand in risk assets, including emerging markets debt.
Exhibit 8
Financial Conditions Remain Highly Accommodative
Goldman Sachs US Financial Conditions Index (Inverted)
97
rose, and fiscal balances deteriorated. However, signs of recovery are
showing. Debt-to-GDP ratios are manageable, especially given the
favorable funding mix, and are now expected to decline (Exhibit 9)
thanks to improved growth, and access to capital through a healthy
new issue market, IMF lending programs, and debt sustainability
initiatives. Meanwhile, fiscal balances are set to improve due to
higher growth, prudent policy measures, and lower expenditures
as pandemic-related spending declines. For commodity exporters,
improving terms of trade should serve as an additional tailwind.
Although commodity prices have come off recent highs of late,
they remain elevated. Additionally, current accounts are also nearly
balanced on the whole, and many countries are accumulating foreign
reserves as an additional buffer.
Emerging markets corporate fundamentals have been remarkably
resilient, and we think their improvement in credit metrics will
continue. Net leverage deteriorated only slightly in 2020, whereas
US and European corporates generally saw leverage ratios increase
around 1.5x (Exhibit 10). Looking ahead, emerging markets
corporates should benefit from the robust rebound in global growth
Exhibit 9
EM Sovereign Debt Ratios Are Manageable and Likely
to Decline
($T)
15
External Debt [LHS]
Local Debt [LHS]
(%)
60
Debt/GDP [RHS]
12
48
9
36
6
24
3
12
0
΄00 ΄01 ΄02 ΄03 ΄04 ΄05 ΄06 ΄07 ΄08 ΄09 ΄10 ΄11 ΄12 ΄13 ΄14 ΄15 ΄16 ΄17 ΄18 ΄19 ΄20΄21F
0
As of 31 May 2021
Source: Lazard, Haver Analytics, JPMorgan
98
99
100
Exhibit 10
EM Corporate High Yield Leverage Is 2x–3x Lower than DM
101
Net Leverage (x)
6
102
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
As of 18 June 2021
4
Source: Goldman Sachs
2
Global EM HY
US HY
European HY
Resilient Fundamentals
While the global backdrop is always a key consideration in the
emerging markets debt outlook, bottom-up fundamentals must not
be overlooked. The pandemic took a toll on emerging markets—both
socially and economically. In 2020, sovereign debt-to-GDP ratios
0
2015
2016
As of 31 May 2021
Source: Lazard, JPMorgan
2017
2018
2019
2020
8
and strong commodity prices as global demand recovers. On a
bottom-up basis, we expect leverage to decline in 2021 toward
pre-pandemic levels and remain well below levels of developed
markets peers, reflecting conservative corporate behavior and the
focus on deleveraging in emerging markets in recent years. By and
large, emerging markets corporates have used the low interest rate
environment and healthy investor demand over the past few years to
refinance existing debt at attractive levels. Additionally, companies
generally have ample liquidity and limited funding needs.
Attractive Valuations in Segments
While the macroeconomic outlook and bottom-up fundamentals are
aligned in favor of the asset class, it is always important to view the
opportunity through a valuation lens. Valuations are not uniformly
attractive across the asset class, and thus, we believe it is important for
investors to be highly selective in this environment. We see compelling
value in three areas in particular: high yield hard currency sovereign
debt, corporates, and increasingly, local currencies.
Spreads in high yield sovereign credit remain elevated, especially
compared to investment grade, and are not fully reflective of the
improving environment. High yield spreads are currently around
570 bps, which is approximately 80 bps wide of pre-pandemic levels
(Exhibit 11). While spreads are unlikely to compress beyond prepandemic levels, we see scope for 25–50 bps of further tightening in
high yield sovereigns. In contrast, investment grade spreads have been
hovering near historical lows of around 150 bps and offer very little
potential for further tightening, although steep yield curves in select
markets offer attractive carry opportunities.
After handily outperforming sovereign credit and local currency debt
in 2020, emerging markets corporates continued to lead the pack
in the second quarter and are the only segment of the asset class to
deliver a positive return thus far in 2021. We expect this resilience
in corporates to continue. While rising interest rates pose a risk to
fixed income returns, emerging markets corporates offer a degree
Exhibit 11
Difference between High Yield and Investment Grade
Sovereign Spreads Remains Elevated
(bps)
1,500
1,200
(bps)
Investment Grade Spread [LHS]
High Yield Spread [LHS]
HY-IG Spread [RHS]
1,000
800
900
600
600
400
300
200
0
2016
2017
2018
2019
2020
2021
0
of protection given their higher spreads and shorter durations in
general. Moreover, emerging markets corporates offer a considerable
spread pick-up over developed markets corporates (Exhibit 12),
despite their current stronger fundamentals. We expect modest
spread tightening to continue over the remainder of 2021 and view
corporates as a structurally attractive source of yield.
Exhibit 12
EM Corporate Bonds Offer an Attractive Spread Pick-Up vs.
US Corporates
Spread (EM-DM, bps)
300
Investment Grade
High Yield
200
100
0
-100
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
As of 13 July 2021
Source: Lazard, Barclays, Bloomberg, JPMorgan
The final area where we see attractive valuations is in local currencies.
Our outlook for emerging markets currencies continues to improve
and is highly constructive over the medium term for several reasons.
We believe the US dollar is likely to weaken due to the broadening of
the global recovery, highly accommodative Fed policy, and growing
US twin deficits. Also, central banks in many emerging markets have
recently begun to normalize policy rates, and the widening of interest
rate differentials within developed markets should further support local
currencies. While emerging markets currencies have lagged other asset
classes, particularly commodities (Exhibit 13), which tend to be highly
correlated to global growth, we expect them to catch up meaningfully.
Exhibit 13
EM Currency Has Lagged the Rebound in Commodities
EFMX REER [LHS]
(Index, 1=31 October 2000)
Commodities [RHS]
(Index, 1 = 31 October 2000)
1.5
3.5
EMFX REER [LHS]
1.4
Commodities [RHS]
3.0
1.3
2.5
1.2
2.0
1.1
1.5
1.0
1.0
0.9
0.5
2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
As of 21 June 2021
As of 31 May 2021
Source: Lazard, JPMorgan
Source: Lazard, JPMorgan
Outlook on Emerging Markets
In the shorter term, however, we are taking a more cautious approach
and have not yet begun to meaningfully add risk due to lingering
uncertainty about the US fiscal and monetary policy mix. The Fed’s
decision on when to begin tapering its asset purchases is likely of
particular relevance in the near term but shouldn’t meaningfully
impact the medium-term outlook for currencies.
Overall, our outlook for emerging markets debt is improving, and
we believe the asset class is poised to deliver strong absolute and
risk-adjusted returns. In the current environment, we believe being
selective—among segments of the market and individual countries—
will be key to capturing these returns.
This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management.
Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a
robust exchange of ideas throughout the firm.
Notes
1 The Economist, 25 May 2021. “An Investment Bonanza is Coming.”
2 Source https://www.reuters.com/world/americas/brazil-central-bank-hikes-interest-rates-eyes-return-neutral-rate-2021-06-16/
Important Information
Originally published on 7 July 2021. Revised and republished on 16 July 2021.
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