EM Corporates Outlook for 2023
Emerging Market (EM) credit fundamentals demonstrated resilience in 2022, driven in large part by strong commodities prices. As we look ahead to 2023, we see a more challenging growth environment. As a result, we expect pockets of weakness to emerge within the EM corporate universe, especially if commodity prices turn significantly lower. In our base case scenario, we expect commodity prices to remain elevated due to disruptions in supply; however, we do not expect levels as high as those seen in 2022.
Weaker commodity price expectations reflect in weaker EBITDA expectations. While our aggregate outlook appears sound, we see differentiated outcomes across companies (see Figure 1). Investors should be aware that a more pronounced differentiation may occur if our bear case materializes.
Figure 1: EM EBITDA average growth expectations and distribution of forecasts.
We think security selection will play a stronger role in successful outcomes than it did in 2022. This is because tighter liquidity conditions increased the cost of funding and made market access more challenging for some issuers. In a contrast to previous years when liquidity was ample, weaker balance sheets may find capital harder to access. That said, the majority of the EM Corporate universe benefits from good liquidity and alternative sources of funding. In addition, as our charts below show, most EM corps will maintain a healthy level of interest cover (Figure 2a) . However, higher funding costs could be more problematic for some parts of the high yield universe which may see borrowing costs increase by more than 100bps (Figure 2c).
Figure 2: Interest Cover Ratio (ICR) forecasts and forecast distributions.
A slowing global economy will present headwinds for most sectors and regions in the emerging markets corporate universe. In such an environment, we do not see any significant regional or sectoral outperformers, except for the consumer sector in Asia and the Real Estate sector in the Middle East, both of which will be helped by a recovery in tourism and travel. While commodities could see some support from China reopening, we do not look for such support to materialize in the near term. Instead, we expect China’s reopening to focus on the domestic services industry and, at least initially, not be a major driver for broad EM corporate fundamentals. Should Chinese infrastructure investment remain strong, we would expect to see a broader positive impact on EM Corporates in the second half of 2023. Our table below (Figure 3) shows our expectation for regional and sector fundamentals; in this table, “mix” means there are both winners and losers within the same sector.
Figure 3: EM Corporates fundamental sector outlook by Region.
EM banks remain in good shape and we see limited systemic risks at present. However, sovereign stress/currency weakness pose risks in weaker jurisdictions like Turkey and Nigeria. In addition, extension risk of bank callable subordinated bonds will likely be a key theme in 2023. The market expects most issuers to call these bonds at the first call date (barring a few exceptions in Hong Kong, Mexico, and Brazil) which seems optimistic as rising funding costs might make such calls uneconomic. This dynamic leaves subordinated bond prices vulnerable to downside surprises and makes us cautious on the space. Apart from subordinated debt, the credit ratings outlook remains broadly stable, though we do see some fallen angel risk. The latter is largely concentrated in China/Hong Kong and does not represent a systemic challenge for the asset class at this point.
Bottom-up credit selection will be important to avoid defaults and generate alpha in EM Corporates next year. In general, tighter funding access will likely keep default rates above average with idiosyncratically weak stories the main driver. Chinese real estate remains the largest contributor to our default forecast even though its contribution is expected to decline meaningfully versus 2022. Excluding Chinese real estate, the default rate for the rest of the asset class is not expected to be much higher than the 10-year average. We would note that, away from these weak stories, there are many winners to be found across many regions and sectors – as the strong starting point of fundamentals provides ample buffers for many EM Corporates.
Figure 4: Corporates with stretched balance sheets and EM Corporate default forecast.
In conclusion, we think differentiation and bottom-up selection is key for generating alpha in EM corporates in 2023. While a slowing global economy and tighter funding conditions present a challenging backdrop, a large part of our universe is starting out with strong fundamentals. Therefore, while we expect default rates to trend above average in the year ahead, there remain a range of stronger stories to be found away from the pressured names and sectors.