The fallout of the Covid-19 pandemic and the attendant shut downs instituted across much of the world have been dramatic in terms of the precipitous falls in economic activity recorded across the world. While emerging markets (EM) are composed of a very wide swathe of countries with very different underlying fundamentals, the overall impact on the asset class has clearly been significant.
Consequently, our expectation is for growth to be negative across most economies and for fiscal deficits to climb meaningfully - in some cases into the double digits. From an investment perspective, one clear implication for us is the bifurcation of EM countries into those with liquidity issues and those with solvency issues, which means that selectivity is going to be key.
Against this, we have to weigh some of the positives. Over the immediate time horizon, there has been clear support from multi-laterals directed towards the most vulnerable nations. Beyond that, the action from developed market (DM) central banks and fiscal authorities has been unprecedented. While this has not been directed at EM, there has been a substantial spillover, both through the financial markets channel, leading to risk premia compression from extreme levels; and through the real economy channel, as a pick-up in final demand in DM augurs well for economic activity in EM, both on the manufacturing and resource extraction front.
Looking to the future, this crisis may herald profound shifts in global trade and supply chains. While it is possible that we may see a trend towards "on-shoring" and automation in the developed world, we believe that supply chains will primarily continue to be diversified away from China. If this occurs, countries such as India, Indonesia, Vietnam and Mexico, to name a few, may benefit.
We now find EM hard currency bonds moderately attractive, though selectivity is key. Investment grade (IG) bonds in EM provide approximately 100 bps spread premium over IG rated US credit, while high yield EM bonds trade at approximately 200 bps spread over US high yield credits. On the local rates side, we focus on countries that provide us positive real rates such as Indonesia and Mexico, as we believe that inflation - while dormant for the foreseeable future - is likely to return quicker to EM than DM.
Finally, after the sharp sell-off this year we find some EM currencies such as MXN attractive. However, we remain cognisant of the fact that currencies are the primary shock absorbers in the event of unexpected external events.
• Global central bank support is likely to remain in place for an extended period of time, which would be highly supportive of continued reduction in risk premia
• Economic activity is likely to recover faster in EM than in DM. This, combined with relatively cheap valuations in EM, should be supportive of EM risk assets
• Economic outlook remains extremely uncertain as economies emerge from lock-downs and infection rates start to spike up again
• A number of structural reforms in EM have been put on hold. Unless these are reinstated once the pandemic is over, long term competitiveness of EM economies could suffer