After the first wave of the Covid-19 outbreak in China and East Asia, and the second wave in Western Europe and North America, a third wave now looks to be building in several Emerging Markets (EM) and frontier countries, says Amundi Asset Management.
EM and frontier countries may be able to benefit from the experiences and best practices that were put in place in countries affected by the pandemic earlier. However, most of them do not have well-equipped health systems and lack the resources to deal with a health emergency vs developed countries. Covid-19 will have very significant negative effects on the economic outlooks for EM, mostly leading to recessions.
International authorities, such as the IMF and the World Bank, have stepped in to support emerging economies. In the current context, the issue is more about an increase in lending capacity rather than the availability of different instruments. The IMF is trying to revamp its instruments to increase the resources it can allocate. One point in the assessment of the impact of debt relief/cancellation is the role of China. In the past years, China has become a more relevant creditor for small economies (resources-rich) around the world.
In order to assess the risks that EM are experiencing, we need to evaluate their fiscal fragility and their external vulnerabilities. Looking at all the variables, we came up with a stress ranking that notes countries like South Africa, Colombia, Hungary or Malaysia as being more exposed regarding both issues. In addition to this, the coronavirus is impacting oil demand and, consequently, hitting EM oil producers and exporting countries. However, the current environment may favour net oil importer countries, such as India, Turkey or even China, by improving their external positions.
On the investment side, sentiment has already started to improve in emerging markets, in terms of asset prices as well as fund flows. We think the key factors to watch going forward will be how long lockdown measures will have to remain in place and whether the risk of a second wave of virus spread materialises once measures are gradually lifted. We are still cautious, looking at what is priced into the market in terms of bad news (earnings deterioration or risk of debt restructuring), and which segments can be more resilient during the downturn or rebound strongly after it.
We see value in EM external debt, particularly in high yield, where spreads have already widened to global financial crisis levels. We see ample value in Bahrain and Indonesia. We think quasi-sovereign debt in Latin America offers attractive risk/reward scenarios across Brazil, Mexico and Peru. Within local debt, our preference is for EM rates, where we see value in Russian assets across both FX and rates. In Mexico and South Africa, we see value in rates, but not in FX. Regarding the latter, we remain bearish, especially on growth-sensitive currencies such as China and South Korea. Regarding equity, we have been relatively defensive: we prefer countries with fiscal buffers (such as China) and with strong domestic bases. On the other hand, we are very defensive on export-, commodity- and tourism-related stories. We believe that Covid-19 will favour countries that are close to autonomous regarding internal demand and less dependent on global supply chains and trade. Internal demand is also negatively affected by lockdowns, but this is where resilience and rebound should take place as soon as situations normalise.
On a longer-term perspective, we see Covid-19 as a driver that will reinforce moves towards de-globalisation, a trend already in place even before the crisis, and strengthen the “regionalisation” theme. This will lead to a focus on new investment opportunities within ‘specific regions’ beyond the traditional geographical perspective. The new Silk Road is one important example of this concept, based on the growing influence of China in the geopolitical landscape and beyond Asia.
The macro view
At what stage of the pandemic are emerging markets? Which countries will be, in your view, most affected and what could be the economic impacts on these economies?
In order to provide a reasonably simple answer, we look at the development of sequential outbreaks across the world. We became aware of the first outbreak episode in mainland China in January 2020; the second outbreak occurred in South Korea and in Western countries (Europe and the US) in the second half of February; finally, over recent weeks, we have seen a sort of third wave occur in emerging and frontier countries. Among EM, in terms of the infection curve, Turkey, Brazil and Russia appear to be most affected, followed by India and Peru. Having said this, at this point, we think it reasonable to highlight that the death tolls are still low in comparison with the levels experienced in developed countries. With regard to this third outbreak, the good news is that EM and frontier countries can benefit from best practices put in place by countries that have already been affected by the pandemic. On the other hand, the bad news is that most EM do not have well-equipped health care systems to face the kind of severe outbreak seen in the already hard hit countries. That said, with regard to the economic impacts, we do not expect that any country will be spared. The combination of a domestic outbreak and the related lockdown measures implemented to contain it, along with the external shocks arising related to weaker demand from abroad and weaker tourist flows, will push EM into recession, the depth and length of which will mainly depend on infection curve dynamics, lockdown duration, and the availability on a global level (accessible to the poorer countries as well) of treatments for the virus and/or a vaccine. The domestic demand struggle will be amplified in the most open economies, the ones well integrated into the global supply chain, or the commodity exporters, as well as in the small ones highly dependent on touristic flows.
What is your assessment of the actions of international authorities so far? Are the announced IMF aid packages sufficient to address the situation?
International authorities, such as the IMF and the World Bank, have definitely stepped in to support emerging economies. For example, the IMF received nearly 100 requests for disbursements or debt relief in the last weeks and it is quickly processing them.
The IMF already has several tools in its portfolio, including the Special Drawing Rights (SDR). There are two emergency financing facilities with less conditionality than a proper IMF programme—the Rapid Credit Facility (RCF) and the Rapid Financing Instrument (RFI)—both accessible to the poorest countries. These can be accessed in addition to a pre-existing IMF programme, with an example being the disbursement under the RCF approved for Niger.
The IMF has different credit lines, such as the Flexible Credit Line (FCL) for pre-approved countries with minimal vulnerabilities and strong institutions (the renewal requested by Colombia for 2020 will likely be approved) or the Precautionary Liquidity Line (PLL) for countries with moderate vulnerability.
In the current context, the issue is more about increases in lending capacity rather than availability of different instruments. What the IMF is trying to do is revamp its instruments to increase the resources available: for example, thanks to recent support from the UK, Japan, the Netherlands and China, the Catastrophe Containment and Relief Trust (CCRT) has been able to provide debt service relief to 25 IMF member countries (US $500 million): among these are DR Congo, Gambia, Mozambique, Nepal and Afghanistan. The IMF is asking for more resources from its members to provide additional debt service relief under the CCRT for a full two years. Instruments such as the SDR are sizable in the context of frontier countries such as the small Sub-Saharan African countries in need of reserves buffers. However, they become less adequate in size if we consider EM and frontier countries as a universe. Again, more resources are necessary.
One last point regarding assessment of the impact of debt relief/cancellation is the role of China. In recent years, China has become a more relevant creditor for small economies (resource-rich) around the world. When we talk about debt relief, we should not underestimate the importance of this non-institutional creditor and the commercial nature of its loans. This can be considered as a limit to the effectiveness of the IMF initiatives and a constraint to get more resources by the US.
Do you expect more monetary and fiscal policies to be implemented? Which countries have more room to act and which ones are more vulnerable?
Overall, EM authorities have shifted to more aggressive easing. At this point, the stimulus is still driven more by monetary policy authorities than by fiscal authorities, with few exceptions. As an example, the South African Reserve Bank cut rates by 100bps recently in an unscheduled meeting, while the Bank of Indonesia (BI) and that country’s Ministry of Finance recently made a coordinated effort to plan a three-year fiscal stimulus package. At its most recent MP meeting, BI remained on hold, favouring macro prudential measures. At this stage, more is expected and should come, in our view, on the fiscal side. Having said that, within the EM universe, beyond the direct assessment of the stimulus as being sufficient to put different countries back on track, we have to consider some associated effects related to policy stimulus where there is little policy room and significant vulnerabilities.
The combination of recessionary growth rates, a strong US dollar, and very low oil prices could trigger rating downgrades (sharp rise seen in recent weeks), currency crises and defaults in the worst cases. In order to assess the difficulties that EM are experiencing, we need to evaluate fiscal fragility and external vulnerabilities. As a simple matter of fact, fiscal metrics in 2020 are going to deteriorate based on recessionary level of growth and fiscal measures implemented to address the Covid-19 crisis. At the same time, a strong US dollar or a weak local currency increase external vulnerabilities. Based on all the variables, we have come up with a stress ranking system that points to countries like South Africa, Colombia, Hungary or Malaysia being more exposed on both counts. Mexico would be in the top positions if we include the contingent liabilities on the fiscal side. This is an exercise that in the current period we continue to update based on the constant news flow regarding macroeconomic factors and policy announcements.
Implications of low oil prices for longer on emerging economies: which countries look set to benefit most?
First of all, we would point out that the fair value of the oil price based on the supply/demand model is much lower currently than it was at the beginning of the year (from around $55/bbl to the current $35/bbl), with the main driver being the collapse in demand. The recent OPEC+ agreement acted on the supply side and has stabilized oil price dynamics for the time being, but it didn’t resolve the huge supply/demand gap. The current environment favours net oil importing countries such as India, Turkey or even China by improving their external positions while it negatively impacts net oil exporter countries such as Russia, Colombia, Mexico and the Gulf countries. Among oil producer and exporter countries, some are suffering more than others as their fiscal break-evens or costs of production are higher. In this regard, Russia is better positioned than most Gulf countries.
The investment outlook
The emerging markets asset classes have been affected by strong outflows. Do you think market sentiment will change and what is the key factor to watch going forward?
Sentiment has already started to improve in EM, in terms of both asset prices and fund flows. We think the key trigger was ‘policy panic’ by global policymakers on two fronts: i) health fears that resulted in the implementation of much-needed lockdown policies which allowed investors to envisage an eventual downtrend in the spread of the virus; and ii) economic depression fears that resulted in much-needed stimulus packages across the world. The combination of these two factors has resulted in markets being able to look through the upcoming period of complete collapse in economic activity.
We think the key factor to watch going forward will be how long lockdown measures will need to remain in place and whether the risk of a second wave of virus spread materialises once the measures are gradually lifted.
What is your assessment of current valuations in emerging markets?
We see value in EM external debt, particularly in high yield, where spreads have already widened to global financial crisis levels. We view HY sovereigns as benefitting from the significant backstops provided by international financial institutions. This has already come into play based on the recent approval of IMF disbursements for countries such as Ghana, Senegal and Gabon.
Within local debt, our preference is for EM rates, where we view the Covid-19 crisis as a deflationary shock. The relatively low level of USD-denominated debt among the major EM sovereigns and the absence of inflationary pressures should allow EM central banks to feel comfortable with their currencies weakening. We see little to no pressure on such central banks to hike rates and expect significantly more monetary easing across the board going forward.
EM currencies are our least favoured asset class. The negative growth shock to EM is significant. The absence of fiscal room among EM economies implies that the bulk of the easing weight is imposed on EM central banks. This will likely erode the carry cushion of EM currencies, leaving the asset class vulnerable to continued underperformance.
Do you expect countries to restructure debt going forward and are these events already priced in?
Yes, we do expect a number of countries to restructure debt in 2020. These include, but may not be limited to, Argentina, Lebanon, Zambia and Ecuador. All four cases are already trading in significantly distressed territory. While we may see more downside from current levels, the bulk of the adjustment has already occurred, in our view, in terms of asset price movements.
What are your main convictions in emerging markets debt and equity?
In sovereign hard currency debt, we see ample value in Bahrain as the single best economic reform story in the GCC region. It also benefits from a significant backstop from its regional neighbours. We also see value in Indonesia, given the macroeconomic gains it has made in the past few years, and we think it will be able to weather the fiscal storm from Covid-19. We think quasi-sovereign debt in Latin America offers attractive risk/reward across Brazil, Mexico and Peru. Finally, for the first time since H1 2019, we think the potential upside in Argentine sovereign debt is greater than the downside.
Regarding local debt, we see value in Russian assets across both FX and rates. We think rates in Mexico have plenty of room to move tighter, especially when compared to Colombia. Regarding the latter, we are bearish on the Colombian peso, as we think the currency needs to weaken significantly further in order to address balance of payment problems. Regarding South Africa, we see value in rates, but not in FX, where the latter has room for more depreciation given extremely weak growth dynamics. Finally, in Asia we remain bearish on growth-sensitive currencies such as China and South Korea. We think the Malaysian ringgit has room for further depreciation, but we view the Indonesian rupiah as already having seen the bulk of its required adjustment.
Regarding equity, we have been relatively defensive: we prefer countries with fiscal buffers (some Asian economies, such as China) as they are better placed to accommodate rising deficits to support growth than those with limited space. Also, at this time, we have a bias for countries with strong domestic bases as we believe they are likely to show resilience during these periods of low economic activities. On the other hand, we are very defensive on commodity-, export- and tourism-related stories, such as Latin America countries. We think Russia remains a long-term conviction story and we believe it will recover as soon as the oil price comes back up. Among sectors, we have strong conviction on technology and IT, and we are tentatively looking at cyclical stories in Asia in light of the improvement we are seeing there regarding Covid-19 spread.
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Unless otherwise stated, all information contained in this document is from Amundi Asset Management and is as of 15 April, 2020. Diversification does not guarantee a profit or protect against a loss. The views expressed regarding market and economic trends are those of the author and not necessarily Amundi Asset Management, and are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading on behalf of any Amundi Asset Management product. There is no guarantee that market forecasts discussed will be realised or that these trends will continue. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any services.