2021 EMD outlook: In the wake of the storm - Principal Global Investors
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Finisterre Capital
December 2020
2021 EMD outlook:
In the wake of the storm
The COVID-19 market crisis was a cognitive shock, similar in magnitude
to the Great Financial Crisis of 2008. Global investors found themselves
surprised and wrong-footed in terms of risk positioning.
After all, a pandemic isn't usually part of the risk management
textbook. We all had to quickly adapt and get a grip on the basic
principles of epidemiology, as markets struggled to make sense of the
pandemic’s immediate macro and market impacts amid repeated
lockdowns, unprecedented policy experiments, V-shaped recoveries,
and eventual news of a vaccine, leading to a massive year-end risk rally
in December 2020.
In many ways global risk assets enter Understanding the impact and evaluating
2021 on fairly solid footing the damage
With a balanced outcome from the United In order to assess what 2021 could look like,
States elections and the recent vaccine it’s essential to draw a correct analysis of 2020
breakthroughs, the end of 2020 marked the macro events, policy initiatives, and market
start of the aftermath—though the storm reactions.
hasn’t yet fully passed.
The extensive use of fiscal spending, widely
A second (or third) wave of infections is still encouraged by global central banks and
unfolding across the U.S., Europe, and some multilateral institutions, was the right answer
emerging markets (EM), including Poland, to the pandemic-driven economic crisis, which,
Hungary, the Czech Republic, Russia, and despite similarities to 2008 in terms of market
Israel. This will almost certainly continue to impact, was quite different in nature.
dampen economic activity and delay the real
The Financial Crisis in 2008 mostly affected
recovery until mass vaccination is achieved.
the top of the global macroeconomic pyramid:
However, what’s changed since the beginning
systemic banks needed massive central bank
of the year is that the world now has a plan,
liquidity support to maintain their capital levels,
and expectations of an upcoming end to the
and thus continue playing their monetary
pandemic have helped raise investor spirits
transmission role during the time it took to
heading into 2021. Moreover, unprecedented
transfer excessive long-term corporate debt
policy stimulus continues to lessen the worst of
from the private to the sovereign balance sheet.
what could have been a major collapse of the
world economic order.
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The 2020 pandemic restrictions during summer holidays,
COVID-19 crisis, and an agonising U.S. election campaign held
The extensive use
however, affected back investors in September and October (when
of fiscal spending,
the much larger a vaccine was hoped for, but not yet in sight).
widely encouraged by
base of the
global central banks Then, a combination of the U.S. election
economic pyramid:
and multilateral outcome—unexpectedly tight, but relatively
primarily, this
institutions, was balanced and without massive civil disorder—
includes individuals
the right answer and confirmation of the effectiveness of three
and small and
to the pandemic- Western vaccines within three weeks triggered
medium-size
driven economic a second massive relief rally, as a concrete end
enterprises (SMEs)
crisis, which, despite to the pandemic could at last be envisaged
at the forefront
similarities to 2008 sometime in 2021.
of the sudden
in terms of market
stop in economic
impact, was quite Where did this leave EM fixed income?
activity. Therefore,
different in nature.
the only efficient
Meanwhile, EM countries engineered their
response was to
own steady recovery from the March shock,
be fiscal, as states
initially attempting to emulate the drastic
were best suited to channel liquidity where
lockdowns and sanitary measures of developed
it was most needed. Governments had to
markets (DM), but with more limited means
substitute for payment of lost wages and help
and policy constraints.
SMEs at the grassroot level through working
capital financing and tax or rent holidays, in To be sure, EM countries experienced their
order to avoid a complete collapse of activity share of hardships, being less equipped than
and a politically uncontrollable surge in their DM counterparts in terms of monetary
unemployment and poverty. tools and more constrained in terms of fiscal
flexibility. Some were the result of disastrous
Monetary policy has also played a significant,
outbreaks linked to lax or inadequate
but more indirect, role. Quantitative easing (QE)
management (Brazil). Others were from
will have led to the absorption of about US$12
the economic pain of harsh, and sometimes
trillion of government debt issuance in 2020 and
misplaced, lockdowns (India, Indonesia). Some
20211. Although the increasingly popular Modern
unfortunate countries experienced both (Peru,
Monetary Theory school of thought might
Argentina). Certain countries, like Turkey, Brazil,
argue that government debt and deficits “don’t
and South Africa, were more exposed to the
matter,” the sustainability of such a fiscally driven
economic impact of the pandemic, largely due
approach was bound to be limited in time and
to policy credibility or flexibility issues going
scope. Hence the criticality of quickly finding a
into the crisis, which were then compounded by
vaccine (which has now been delivered).
weak growth and capital outflows.
The market recovery from the depths of March
China and northern Asia were the notable
2020 played out in two phases. The March–
exceptions, due to their more solid finances,
August global risk rally occurred in lockstep
quick sanitary response, and experience from
with “whatever it takes” fiscal and monetary
earlier pandemics. Meanwhile, Russia and
responses. This, in turn, supported the (partly
Mexico paid a high price in terms of growth
mechanical) “V-shaped” recovery in global
and virus impact but retained a lot of policy
activity, as the strictest initial lockdown measures
flexibility thanks to prudent monetary action
were lifted. The advent of a second wave in
and responsible fiscal management.
Europe, following the widespread relaxation of
1 As of November 24, 2020. Source: JP Morgan Emerging Market Debt Outlook.
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But the most salient event risks were found the U.S. elections,
among frontier countries, especially in Africa, lingering effects The absolute and
Central America, and the Middle East. While of the massive DM relative valuations
officially less affected by the virus, several of policy stimulus, in EMD are currently
these nations have been pushed to the brink of and concrete cheap, offering
default or restructuring. Ballooning twin deficits, expectations of a desperately
unsustainably high debt to GDP ratios, and weak decisive cure for needed yield and
oil and commodity prices have made their debt COVID-19 in 2021. liquidity amidst a
dynamics unsustainable amidst a closure of positive global risk
The short-term
USD refinancing markets. Lebanon, Zambia, and environment.
EM-DM growth
Suriname have each officially defaulted since the
differential is
start of the pandemic, and Sri Lanka will likely join
positive
them before long. Meanwhile, Iraq, Oman, Costa
Rica, El Salvador, Angola, Gabon, Tunisia, and The logical political-economic inclination of EM
Pakistan retain precarious debt dynamics. While policymakers to eventually let most economies
some will restructure, the outlook on others is reopen despite a lingering virus risk, has allowed
hinging on a quick normalisation of global trade growth to recover more steadily across the EM
and commodity prices, which may not happen universe than in Europe or the U.S., which had to
before upcoming maturities are due. restrict mobility again to fend off a second wave
of infections. This sets the EM versus DM growth
However, most of differential on a positive trend over the next three to
these significant EM six months, as we wait for the mass distribution of
However, most of
country-level risks a vaccine, which would then likely allow DM growth
these significant EM
are well identified, to catch up more meaningfully from the sell-off in
country-level risks
and investors aren’t the second quarter of 2020. This factor alone should
are well identified,
overly exposed, allow EM equities and currencies to continue their
and investors aren’t
precluding the risk valuation catch-up against DM assets into the first
overly exposed,
of systemic crisis. quarter of 2021.
precluding the risk of
Although the EM
systemic crisis. For now, oil and commodity complexes remain
sovereign default
rate rose to 10.6% supported by several themes. Namely, these
in 2020, we expect include the continuing Chinese recovery, hopes of
it to moderate in 2021; corporate defaults have an upcoming global recovery in 2021, the relative
remained low, at around 2.6%2. supply discipline of OPEC+ countries, and iron ore
and copper supply restrictions—all of which add
Into 2021 with “Goldilocks” fundamentals, fundamental support for the EM narrative.
valuations, and technicals U.S. policy mix, rates, and liquidity flows
Notwithstanding the above challenges, EM The outcome of the U.S. election, while not fully
countries are set to enter the new year with an expected, is also an ideal outcome for EM. A tight
improving fundamental narrative. The absolute result and a hung Congress mitigate the risk of
and relative valuations in emerging market debt unchecked U.S. fiscal spending, but don’t preclude
(EMD) are currently cheap, offering desperately significant stimulus potential for the last few
needed yield and liquidity amidst a positive months of the pandemic. This limits the chance of
global risk environment. These valuations are massive U.S. yield widening and curve steepening,
supported by the balanced policy outcome of which could damage EMD total returns next year.
2 As of November 2020. Source: JP Morgan, BAML.
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Meanwhile, in terms EM hard currency should continue to benefit
Less U.S. fiscal of policy mix: Less Such an environment should help hard-currency EM
spending should U.S. fiscal spending sovereign and corporate credit spreads, as well. We
be met with more should be met expect U.S. yields to only widen moderately, either
forceful liquidity with more forceful because DM growth may take longer to materialise
provision by the U.S. liquidity provision amidst legacy effects of the pandemic or because a
Federal Reserve, by the U.S. Federal forceful Fed may venture into yield curve control if
which should keep Reserve (Fed), needed in 2021. EM credit spreads in the high 300
the global search for which should keep basis point (bp) range with a BB+ rating continue
yield alive—and send the global search to trade near the wide end of their 12-year trading
excess USD liquidity for yield alive—and range (250–400 bps), which compares well with their
flows towards EM send excess USD DM high-yield and investment-grade peers in terms
assets. liquidity flows of valuation and liquidity.
towards EM assets.
Historically, that’s EM corporates have solid sector-level stories
often been the case EM corporate credits remain a relative laggard in
in global recovery environments. However, a key terms of inflows, but retain solid fundamentals
factor in upholding a positive EM risk view into across various sectors—particularly telecom, Latin
2021 will be the degree to which the drift wider in mining and metals, Chinese property, Brazilian
U.S. Treasury yields (which should accompany a proteins, and pulp and paper. Exporters and USD
recovery) will remain driven by higher breakeven earners have also benefited from the drop in their
U.S. rates, rather than real rates widening. respective currencies, while the performance of
metal producers generally tracked the Chinese
Expect ongoing EM currency performance in
industrial recovery.
the near term
The tighter-than-expected U.S. election result has In fact, on an aggregate basis, investors have been
somewhat dented the prospects of extreme USD surprised at the lack of extreme credit events in the
weakness. Despite its twin deficits, widespread corporate world. This is largely due to the lack of
chatter about the end of U.S. exceptionalism, or explosive debt structures and constant refinancing
the erosion of the USD’s reserve status, the U.S. at ever lower yields over the last few years. Even
economy will likely remain at the forefront of any the most stressed Brazilian airlines saw their
sustained DM growth rebound later in 2021. But bond prices recover, as they returned to positive
the more consistent rebound of EM economies cash flows in October 2020. Continuing policy
should help EM currencies perform on their own accommodation by most EM central banks and the
growth and valuations merits, at least over the next steepness in local yield curves should also help EM
three to six months. financials to adequately manage an inevitable rise
in non-performing loans. This should make select
This is a rare moment in the cycle. Despite financials Additional Tier 1 bonds an attractive loss-
the perennial use of currency weakness by adjusted income opportunity.
EM policymakers as a quick fix for their policy
credibility issues and the unimpressive carry Where to look for EM local-bond exposure
available after massive rates cuts in 2020, the Two potential caveats could affect the case for EM
relative valuation of EM currencies (in real terms) local-currency bonds as an asset class going forward:
and the expectations of faster growth in EM than
• t 4.5% for 4.5 years of duration, the average
A
DM can continue to lead EM currencies higher into
yield across the asset class is at its lowest
the first quarter of 2021.
level ever.
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• he substitution of external debt issuance
T We expect the current broad-based rally to
for local issuance, sometimes helped by EM carry over into January, though some valuation
central bank QE experiments (e.g., Indonesia, hiccups are always possible along the way. A likely
South Africa, Poland), still implies the potential worsening of the virus situation in the U.S. and
for more issuance, which has contributed to Europe after Christmas, combined with the usual
curve steepening. January EMD issuance binge, may provide some
excuses for a short-term valuation shakeout.
That said, opportunities do exist in the steeper
curves of Brazil and South Africa, which have If the current trend
probably priced in the worst of the fiscal pressures is maintained, we If the current trend is
and are now likely to try and adjust. Higher-yielding expect that, by the maintained, we expect
countries with policy flexibility, such as Mexico, end of January, that, by the end of
Russia, India, and Indonesia, also remain attractive, EMD assets will January, EMD assets
with 6%–8% yields in the ten- to 15-year segment. have reached what will have reached what
Additionally, high real yield opportunities remain in we perceive to be we perceive to be their
places like Peru, Egypt, and potentially Ukraine. their fundamental fundamental fair value.
fair value. Another
EMD technicals amid a dearth of DM credit
30–40 bps of spread
issuance
tightening on the JPMorgan EMBI Global Index
Technicals will remain and a 5%–7% further rally in EM currencies will
Technicals will biased towards further bring us there.
remain biased EMD inflows, as global
towards further “crossover” investors To fair value and beyond
EMD inflows, as and balanced “60/40”
global “crossover” funds struggle to find However, the EMD rally is likely to continue beyond
investors and DM sources of yield fair value, due to a number of factors: animal spirits,
balanced “60/40” with some degree of positioning issues, the search for yield, and relative
funds struggle to liquidity. The 2021 value versus other, richer traditional asset classes.
find DM sources supply of U.S. credit Based on insight from our own interactions with
of yield with some is expected to be the a diverse global client base, we understand that
degree of liquidity. lowest in 12 years3, larger institutional mandates and strategic asset
with yields starting allocations are being awarded to EMD assets,
the year at multi-year to be funded in the first few months of the new
lows yields, as well (in USD terms). EM fund flows year. (That’s after the initial involvement, since
have already started to reflect an escalating trend, September, of crossover investors, retail investors,
with a bias towards hard-currency sovereign debt and global private banks.) This could push spreads,
inflows since September. Yet, a lot of potential yield, and currency values well beyond their
remains for a return to more normal ownership perceived fair value.
patterns, with EM local-currency assets receiving
During that period, we will continue to maintain
more attention. In such a context, an expected
long positions on currencies and high-yield names
surge in EM sovereign and corporate credit issuance
across the board, favouring “momentum” assets
next year would most likely be well received.
and spread compression trades.
How long can the current rally be sustained? This EM honeymoon will likely last until the benefits
of mass vaccine distribution start to become a
Despite our rare enthusiasm for all EMD asset macro reality across the U.S. and Europe. The
classes heading into 2021, our full-year outlook vaccine trade will probably be more of a DM
warrants a clearer sequencing.
3 As of November 2020. Source: BAML.
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trade than an EM one, which will eventually lift • More conservative consumer behaviours
developed economies out of protracted lockdown for longer (as seen in China, long after the
situations, while many EM economies will be at the economy’s full reopening)
end of the delivery queue. Additionally, benevolent • Growing pains; while an irreversible change in
G7 central banks and governments may try the business models of many sectors—including
and prolong the spending party (not taking any entertainment, travel, transportation, high
chances with growth this time). This easier policy, street retail, commercial real estate, and cultural
together with stronger evidence of reflation, products—will eventually lead to new sources
could make a case for a return to growth stocks of growth, companies will first need to go
and the USD, for a while. Although this does not through a period of adaptation marked by
necessarily portend disaster for EM, the spread uncertainty around corporate investments and
tightening and currency appreciation trends may revenue streams
stall at that point, especially if wider U.S. Treasury
yields—led by higher real yields—start questioning Ultimately, we have to understand that we can’t
the Fed’s “laissez-faire” attitude. reasonably expect to have our cake and eat it, too. In
other terms, either the legacy impacts will disappoint
The initial EMD expectations of a quick normalisation, or a successful
The initial EMD rally may therefore global normalisation in activity will quickly give way
rally may therefore give way to some to calls for fiscal retrenchment in order to avoid
give way to some profit taking and future policy mistakes and distortions. This is the
profit taking and retracement risks main reason for our more sober outlook for the
retracement risks around the end second half of 2021. Although, to be sure, global
around the end of 2021’s second policymakers will continue to make a conscious
of 2021’s second quarter. At that point, political-economic choice to take some risks on
quarter. a more stable “grind inflation and future policy credibility, in order to
tighter” environment give growth a chance to address growing public
is likely to set in, with discontent and rising income inequalities, as well as
investors focusing on compounded income and prevent future governability issues.
a mild tightening in spreads, as the U.S. treasury
yield repricing finds some limits. We believe the Ultimately, EMD asset class returns are likely
right approach will then be to refocus on income to be satisfactory in 2021, though the year will
as a performance anchor, along with the search remain challenging for EMD investors. Adequate
for alpha opportunities from special situations or management of market timing and successfully
cross-country relative value trade ideas. alternating between various sources of returns
will be key in an environment where fundamental
A more sober second-half outlook value may not
appear obvious at
We remain mindful of the inevitable lingering times—and one in In 2021, most capital
impacts of the current crisis, which make us doubtful which relative value gains will likely be
on the prospect of a durable resurgence in global considerations and realised early in
inflation. Despite the arrival of a vaccine, there are technical factors the year, while the
several risk factors that will likely make for a slower will likely play a second half may be
recovery process than many expect: critical role. In more focused on
• The permanence of “zombie” companies, which 2021, most capital income generation
are being artificially supported by policy stimulus gains will likely and relative value
be realised early considerations.
• Higher structural unemployment
in the year, while
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the second half may be more focused on income The timing and
generation and relative value considerations. sequencing of The limited policy
monetary and headroom inherent to
What we’re keeping an eye on in 2021 fiscal “exit” several EM economies
policies will also will pressure quite a few
China: A new reserve currency? be a prominent of them to straighten
China (indeed, Asia) has been the consensus trade focal point of the their fiscal balances
of year-end 2020. Its growth relative to both EM normalisation earlier than their DM
and DM, pandemic control, forceful fiscal support, landscape next counterparts.
and the inclusion of Chinese government bonds year. The limited
in core global bond indices with a 10-year yield of policy headroom
3.3%, have all made for a fairly obvious macro trade. inherent to several EM economies will pressure quite
However, Chinese momentum may plateau into a few of them to straighten their fiscal balances
2021, as the country tries to pivot from a fiscally earlier than their DM counterparts. Indeed, even
driven industrial reflation towards a monetary with the growth and political risks of premature
policy-driven consumer reflation. Meanwhile, the tightening, fiscal normalisation will look like a
long-term reform of China’s domestic financial necessity in certain stretched situations. In our view:
system will continue, allowing credit defaults to • Brazil will need to quickly reassure local investors
occur as collateral damage, which could occasionally with positive signals of a fiscal retrenchment
spook risk appetite. This maturation of domestic in early 2021, given precarious domestic debt
markets remains a necessity to attract and retain dynamics.
foreign investor flows into its domestic markets, at
• South Africa will try and deliver on R230 billion
a time when China becomes a structural importer
in public sector wage cuts, while proceeding to
of goods and capital. Nonetheless, we expect
restructure its state-owned electricity utility
Chinese government bonds to remain an attractive
company Eskom.
structural opportunity in this environment—though
the renminbi rally may stall at some point in 2021, • Turkey will have to contend with the policy
when growth momentum starts to slow. impasse of low rates and lax fiscal policies when
running a negative currency reserves position,
All eyes on normalisation trades particularly as the population begins to stop
A sizeable amount of investor brain power will be regarding the currency as a store of value.
dedicated to contemplating “normalisation” trades
Although these core EM economies still control their
in 2021.
destiny, we believe early policy normalisation would
Tourism normalisation, though likely to play out go a long way toward turning them into potential
later in the year, should help many countries success stories for 2021 (even despite the difficult
rebound from 2020 challenges. In particular, Turkey, political trade-offs, in some cases).
Tunisia, Egypt, Morocco, Dominican Republic,
Peak oil
Sri Lanka, and Thailand may see their prospects
improve, given that tourism-related inflows have Although we aren’t expecting any major collapse in
historically accounted for between 7% and 13% oil prices, we see limited upside to current levels. It’s
of their respective GDPs. The same applies to probably reasonable to expect a range of US$45–55
the potential recovery of remittance flows from per barrel, given both pent-up supply risk from some
foreign workers, which act as a substantial balance desperate OPEC+ members and the potential for
of payment support in some cases. Sri Lanka, the resumption of U.S. shale production.
Philippines, El Salvador, Costa Rica, and Ecuador are
especially likely to benefit from this trend.
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On the consumption side, more major global Private sector involvement in future EM
economies are drawing up transition scenarios debt restructurings
and enacting a strategic pivot toward renewables, The pandemic also prompted the G20 to first
while the demand for electric vehicles has grown adopt, and then extend, a Debt Service Suspension
exponentially in 2020. This gives rise to speculations Initiative (DSSI) targeting bilateral and multilateral
of peak oil demand hitting much sooner than debt relief for 73 poorer countries. This has been
expected. 2021 will likely be a test year for these accompanied by loud calls from global policymakers,
newer supply-demand dynamics, which may lead to the International Monetary Fund, the Organisation
a reassessment of the debt sustainability prospects for Economic Co-operation and Development, and
of several EM oil producers, including Angola, Gabon, the World Bank for more automatic private sector
Iraq, Ecuador, and Oman. involvement in future debt restructurings.
Government spending in 2021: A chance However, the efficacy of these petitions is likely to be
to prioritize Environmental, Social, and Corporate limited by the lack of a convincing legal mechanism
Governance (ESG) to compel private debtors to agree to terms
The COVID-19 crisis has created a unique occasion conflicting with their fiduciary duties. Yet, we only
for global governments to regain control of the expect these calls to grow louder in 2021, as G20
policy agenda through use of the fiscal lever, governments lack the means of their generosity and
while also prioritizing ESG issues. Many of them will be forced to reduce their own spending.
have rightly seized the opportunity to condition
their spending around environmental targets (for A new U.S. administration, a new role on
example, 37% of the recently approved 750bn EUR the international stage
European Union fiscal package will have to be spent It is widely expected that a Joe Biden presidency
on energy transition projects), in what could be a in the U.S. will mark a U-turn from the previous
historic turnaround in the global mindset regarding administration’s isolationist—and, indeed, sometimes
sustainable growth. Given enough fiscal support, a antagonistic—approach. We expect that a return
profitable green economy is suddenly no longer just to some degree of multilateralism and “play by the
wishful thinking. rules” behaviour is in the cards, as indicated by the
decision to re-join the Paris climate agreement and
In fact, 2020 has already the World Health Organization. We also note the
Given enough seen something of consensual nominations in the State Department,
fiscal support, a revolution in ESG hinting at a re-empowering of American diplomacy.
a profitable thinking across the EMD
green economy investment community, A containment approach to China will remain a
is suddenly no as well. It seems that strategic objective, with the human rights angle
longer just wishful EM portfolio managers around the Hong Kong situation likely more
thinking. have realized their prominent, a Biden presidency is very likely to try
collective power in and enrol its European allies in a more concerted
driving more sustainable approach. We also expect to see a re-engagement in
policy choices from EM governments, as well as their negotiations with Iran on a potential nuclear deal. All-
potential impact in addressing climate change through in, our forecast calls for a more predictable approach
direct interaction with the largest carbon issuers. to geopolitical challenges—an approach that may not
yield fast results, but that should contribute to lower
Finisterre continues to develop its approach towards potential event risks for global markets.
a more activist role in that respect, and 2021 is slated
to see an increased adoption of ESG objectives across
most of our investment processes.
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Principal Global Investors. Principal Global Investors leads global asset management at Principal®.
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