Positive growth backdrop, but uncertainty on the timing of easing cycles

Emerging market (EM) fundamentals remain resilient against a backdrop of firm global growth, but uncertainty over the timing of easing cycles may limit the performance of EM assets. While Asian growth is projected to be healthy, growth is picking up from a low base in Latin America, and in Europe, the Middle East and Africa (EMEA).

We have revised up our EM growth forecast to 4.2% from 4.0% last quarter. We are seeing a gradual normalisation of growth in the European Union and have revised our forecast up. In contrast, US growth is expected to be on the slower side compared to 2023. Overall, our forecast for the differential between EM and developed market (DM) growth–the EM-DM growth alpha–remains unchanged from last quarter at 2.6%, which continues to be above historical levels (Exhibit 1).

The bulk of EM disinflation is now done and inflation is no longer the tailwind that it was. Inflation is moving sideways in a number of EM countries and regions such as EMEA may also face some upside risks. In particular, some central European countries are mainly driving European inflation. Although the disinflation process has stalled, some EM central banks still have plenty of room to cut interest rates, especially compared to the recent hawkish re-pricing of rates. However, the timing of rate cuts from the US Federal Reserve may limit the size and pace of EM easing cycles.

China GDP upgraded

We have upgraded our 2024 GDP forecast for China to 5.0%, from last quarter’s 4.8%, on the back of better-than-expected first-quarter net exports and recent policy support for the housing market, which limits downside risks. For the full year, we expect exports to be a positive contributor to GDP, supported by resilient global demand and a new technology cycle, driven by investment in artificial intelligence.

Consumption data remains resilient, with tourism-related spending and electric vehicle (EV) sales continuing to be the key supporting pillars for the Chinese consumer (Exhibit 2).

The housing market has continued to underwhelm, under pressure from weak sentiment due to falling home prices, although there has been a slight deceleration in the rate of decline in secondary house prices. China’s central bank, the People’s Bank of China (PBoC), recently arranged a CNY 300 billion relending facility for government home purchases and we expect more supportive actions from the government if current measures prove insufficient to stabilise the housing market. We will very likely see a pickup in home sales in June for seasonal reasons, but the future path of contracted sales is still highly uncertain.

Deflation in China is gradually fading, but is still contributing to global disinflation. However, the disinflationary impact of China’s exports on DM inflation is increasingly threatened by new industrial policy decisions in the developed markets, including risks related to sanctions and tariffs. We expect some fiscal support from the government to support exporters faced with substantial tariffs (in the order of 50% or more). However, tariffs on Chinese exporters are expected to be limited to just a few sectors and not broad based. If the tariffs are not substantial, then Chinese goods will remain competitive.

Soft vs. firm landing scenarios

Year to date, EM returns have been more consistent with a firm landing scenario, which is more of a neutral scenario for EM assets. Any upside from here will come from the market moving towards a soft landing scenario, which is our base case. In the absence of any major economic shock, we believe the most likely scenario from here is for a soft landing to be achieved (Exhibit 3).

Our soft landing base case scenario could still generate high single to low double-digit returns across EM markets for the rest of the year, consisting of a combination of carry, duration and risk rally. While we have increased the probability that growth will reaccelerate to 10%, from 5% last quarter, this scenario remains a low probability tail risk. Given that we see recession as a higher probability scenario than a growth reacceleration, the risks of a US economic downturn appear to be mispriced. In the case of a US recession, EM returns would be expected to be low, but better than in a reacceleration scenario.

With EM central bank cutting cycles shortened by uncertainty around the timing of US rate cuts, we prefer to be selective in our long and short rates positioning, as idiosyncratic stories will likely have a higher influence on market beta.

The US dollar has stayed strong and carry trades have worked for an extended period of time. FX volatility has been low but is likely to pick up around the US election later in the year. Against this backdrop, we prefer to keep our FX engagement on the lower side and to be selective in FX carry trades as well.

In sovereigns, we prefer to buy sovereign credits where there is evidence of fundamental improvement and where there is incrementally more supply in the local market. And in EM corporates, with spread valuations stretched and the all-in yield looking attractive, we continue to rotate into quality carry names.

EM local currency debt outlook

EM local currency performance has been driven by duration and carry so far this year, with very little differentiation. Disinflation is still in place and EM rates are behaving well. Our strategy continues to be long duration where there is central bank support. Rate cuts from the Fed and the European Central Bank (ECB) would therefore help to further strengthen our conviction in our duration positioning. We hold a long currency (FX) bias but wish to trade tactically depending on the speed of the US slowdown in coming months. A Fed rate cut by June would likely be the key alpha driver for next quarter.

We hold a structural long bias towards Asian rates and have conviction in our overweight duration position as we continue to see no inflationary signs in the region.

Central and eastern Europe (CEE) countries should continue to see disinflation, while there is no inflation momentum in Latin America currently. We intend to take overweight positions in these regions, where central banks are cutting and real yields are high. We also intend to explore select frontier names with positive idiosyncratic stories.

In terms of FX, we come from a position where carry opportunities were very high and therefore expect these opportunities to be challenging this quarter. Against this backdrop, we intend to gradually shift away from carry opportunities, adding quality positions where we see relative value. 

EM sovereigns outlook

The EM sovereigns sector remains our preferred EMD sector given the resilient growth backdrop, although country differentiation is still the key theme in the market. We have recently seen attractive reform and turnaround stories in the single B space and expect reform momentum to continue, with the International Monetary Fund providing support. Valuations are bifurcated, with investment grade and BB names trading at fair value; whereas the single B and distressed bucket are the spaces where value can still be found. The technical picture remains strong with a lot of cross-over demand.

The majority of the index (~90%) is benefiting from higher yields and will be dependent on Fed cuts for further spread compression. The lower quality bucket (~10%) is still cheap and we expect spread compression here as the segment is relatively indifferent to the timing of Fed cuts. Against this backdrop, we are changing our strategy, moving underweight spread duration and tilting to an overweight duration time spread (DTS) positioning.

For the next quarter, we intend to look into some of the BB winners where we are still finding value, as well as exploring short duration opportunities where carry is looking compelling, and CCC/distressed credits, which are catching up with the strong macro data amid rising demand for risk assets and a pick-up in value. 

EM corporates outlook

Corporate fundamentals remain stable, with a favourable growth outlook and resilient balance sheet strength providing a buffer for the asset class. Asian corporates are expected to lead in terms of EBITDA (earnings before interest, tax, depreciation and amortisation) growth, followed by EMEA and Latin America. The Asian technology, media and telecom, and consumer sectors would be expected to be the key contributors to growth. We expect most sectors to grow, except for real estate, EMEA metals & mining, and Latin American utilities. Default rates are expected to come down to levels that are broadly in line with developed market peers, while sources of risk remain idiosyncratic rather than systemic. The debt maturity wall peaks in 2026, with financials and real estate facing large maturities at this time. We find that the names at risk are idiosyncratic in nature and unlikely to result in broader spill over to the rest of the EMD market.

Corporate valuations are quite tight in an environment where the market is looking for carry. Total return metrics are compelling despite tighter spreads, which we think can stay tight for a while in an environment where fundamentals remain supportive and the carry story continues to play out. Net financing is predicted to be a large net negative for 2024. Asian investment grade corporate issuance continues to decline significantly, offset by more issuance in EMEA, particularly from the Middle East and Turkey. As a result, we continue to focus on relative value opportunities and a high carry basket. We have room to add risk and are also comfortable to include high yield exposure; however, bottom-up stories are important and we will look for comfort where refinancing risks are minimal.

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EM sovereigns outlook

A lack of inflows and tighter valuations hindered EM sovereigns. Nevertheless, investors continue to hold their long positions and are not willing to sell at current levels. As such, we think that higher for longer may not be necessarily a bad scenario for the sector given the high carry environment and resilient underlying EM fundamentals. Technicals are inversely proportioned to valuations and are looking strong. A number of countries are issuing in local markets, providing more stability for funding their outstanding debt. Absolute return expectations for the sector remain strong given the high carry environment. As a result, we continue to like diversified short duration carry baskets.

Spread valuations are tighter than last quarter. Investment grade securities continue to be expensive but are still attractive compared to their DM peers given higher yields and strong crossover participation. Specifically, BB rated names are slightly cheap compared to BBBs, and are looking attractive (Exhibit 5). There is also still value to be found in the single B and CCC segments. However, the contribution from these ratings will be smaller given their smaller index weight.

EM corporates outlook

Corporate fundamentals remain stable, with most sectors other than Chinese real estate still expecting positive EBITDA (earnings before interest, tax, depreciation and amortisation) growth in 2024. We expect the strongest earnings growth momentum in Asia, followed by Latin America. Earnings growth in central and eastern Europe, the Middle East and Africa (CEEMEA) is expected to be relatively flat year over year.

From a sector perspective, we expect more positive momentum in the consumer, utilities, oil & gas, and metals & mining sectors. Company balance sheets remain strong across all regions and most corporates have a buffer to absorb a higher rate and/or lower growth environment. Local currency markets, as well as both international and local bank lending, remain viable alternative funding sources for a large part of the universe, providing an additional buffer. However, in the event of prolonged rates stress, we believe 12% of high yield issuers, excluding the idiosyncratic names in Chinese real estate, would come under pressure. At this stage, we view this stress case as a low probability tail risk.

Overall, corporate index spreads are at historically tight averages, though in the EM high yield market the BB segment in particular may still have some room to tighten (Exhibit 6). We would also highlight that index duration has shortened and the quality component of the index has increased over the past few years, which if adjusted would see the index trading at tight levels rather than historically tight levels. Credit markets can remain in low spread ranges for extended periods, and the current overall yield is still historically attractive.

Our focus for next quarter will be on relative value and high conviction carry trades across regions. From a relative value perspective, we see the most value in Latin America, followed by CEEMEA and Asia.

The technical picture remains strong on the back of large negative financing, driven by Asia. Given a strong fundamental and technical picture, as well as an overall constructive view on global growth, we are comfortable with some duration exposure where we think there is adequate spread cushion. Overall, we are traversing close to the benchmark given the tail risks of a firm landing and a growth reacceleration. In the case of any pickup in inflationary pressures, we are well positioned with a current bias towards quality carry.