In brief
- Our base case remains for resilient emerging market (EM) growth and for a developed market (DM) soft landing, which should be supportive for emerging market debt (EMD) assets.
- EM-DM growth alpha remains high despite stronger US growth. EM inflation is better anchored than DM inflation, while EM central banks still have room to cut, albeit the pace of easing may be challenged by the timing of Federal Reserve rate cuts.
- Our soft landing scenario implies lower US Treasury yields, a weaker US dollar and strong EMD returns of 8%-10% in 2024.
Resilient EM growth outlook remains intact
EM fundamentals remain supported by significant bottom-up improvements, especially in frontier markets. China is still the largest emerging market, but its influence may have peaked, meriting greater attention to emerging markets outside of China. We expect EM growth to be around 4% in 2024, supported by stability in Asia and an expected recovery in Latin America in the second half of the year. We have revised our US growth forecasts upwards and expect sub-trend growth in Europe, with a gradual stabilisation. Despite the upward revision to US growth, we expect a healthy EM-DM growth alpha of around 2.6%, which is above historical levels (Exhibit 1).
EM inflation continues to decline in Europe, the Middle East and Africa (EMEA), and in Latin America, while remaining low in Asia. Benign EM inflation forecasts should give EM central banks room to cut interest rates into 2025. However, potential delays to US rate cuts have raised questions about how fast EM central banks can cut their own rates.
We are slightly more positive on China than the market consensus
We estimate China will grow by 4.8% in 2024, which is on a par with 2023. However, growth last year benefited from favourable base effects, so we think that to achieve the same growth this year will require more fiscal, credit and monetary policy support. While market sentiment is bearish on China, we are slightly more positive as we think that the current news is, to a large extent, already priced in, while policy support should help ensure economic targets are achieved, boosting broader emerging market growth.
While the nominal fiscal target remains at 3%, an additional CNY 1 trillion government bond arrangement, on top of the CNY 1 trillion issued in the fourth quarter of 2023, raises the effective nominal fiscal deficit to close to 3.8% of GDP. Additionally, pledged supplementary lending (PSL), tax cuts/rebates, and other credit measures should push the fiscal deficit higher still. Monetary policy continues to be accommodative, and while further accommodation is expected, any easing would be expected to be implemented in a more targeted way. Money supply will be managed in line with economic growth and inflation targets, which implies higher inflation – an important target for the People’s Bank of China (PBoC) this year.
The real estate sector remains under stress, with 2024 sales forecasts downgraded due to weak sales in the first two months of the year. Sentiment shows few signs of picking up, despite a slight deceleration in the pace of house price falls in January. While the outlook for Chinese real estate remains challenging, we expect less drag from housing, which is supported by major projects. Also, while the sector’s contribution to total GDP has been falling, other sectors (such as new energy) are picking up the slack (Exhibit 2)
Soft vs. firm landing scenarios
Under our base case soft landing scenario, we expect sub-trend US growth with inflation closer to target, providing a backdrop for modest Federal Reserve (Fed) rate cuts (Exhibit 3). In this scenario, EM-DM growth alpha should improve as the US economy slows down, while EM central banks can continue with their cutting cycles as EM inflation continues to decline. Although year-to-date emerging market debt (EMD) returns have been underwhelming, after a strong end to 2023, asoft landing would provide a positive risk and duration backdrop for the asset class. The soft landing scenario implies lower US Treasury yields, a weaker US dollar and strong EMD performance of 8%-10% in 2024, with local currency debt outperforming.
We believe the probability of a US recession has decreased on the back of improved US growth data, while so far the market is also not pricing arecession. This quarter we have included an additional “reacceleration” scenario to the right of our roadmap, which would be the worst for EMD assets. Currently, we assign a very low probability to a reacceleration scenario. Instead, we think the most likely alternative scenario to our base case is a firm landing, in which the Fed may not be able to cut policy rates much this year as inflation does not fall quickly enough. A firm landing scenario could lead to a re-pricing across the EMD complex, leading to flat total returns. Ultimately, however, a firm landing scenario could provide a better entry point for adding risk and duration to portfolios.
As we move away from the left tail of recession, we prefer high quality names and selected stressed names. Thereare also significant bottom-up stories across the asset class given the potential for more credit rating upgrades than downgrades this year. We will therefore look to rotate out of high beta credit positions into names that offer more carry as bottom-up improvements are priced into markets.
EM local currency debt outlook
EM local currency performance has been driven by duration and carry so far this year, with very littledifferentiation. 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 longcurrency (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.
