Emerging markets have been hit by stern economic challenges in 2022. But many companies are proving resilient thanks to strong fundamentals, as our emerging market corporate debt team explain.
Read this article to understand:
- How EM countries face diverging fortunes
- The relative resilience of EM corporates
- Why EM corporate debt investors need to be diligent and selective
In June 2022, Pakistan’s government made an unusual request of its citizens: drink less tea. Planning and development minister Ahsan Iqbal asked people “to cut down the consumption of tea by one to two cups” per day so the country could reduce the $600 million it spends annually on tea imports.1
A storm in a teacup, perhaps – but the story illustrates the acute pressures faced by emerging markets at a time of rising inflation, supply chain issues and global monetary policy tightening.
Not all emerging economies are alike, however, and some debt markets are performing better than others. Many large emerging market companies are proving notably resilient, for example.
From Chinese tech behemoths to Indonesian consumer goods specialists, from Brazilian banks to Nigerian telecoms giants, these companies often boast strong balance sheets and retain access to funding. As such, they should be better positioned to withstand growth slowdowns and inflationary pressures than heavily indebted sovereigns. These firms could present attractive opportunities for investors during a turbulent period.
“The story of emerging markets in 2022 is partly about real weakness versus perceived weakness,” says Amy Kam, senior portfolio manager, emerging market debt at Aviva Investors. “Some regions have been hit harder than others by inflation and the tightening cycle and have underperformed as a result. But corporate fundamentals remain strong.”
Out of the frying pan…
Emerging markets were badly affected by the coronavirus pandemic in 2020, as China locked down, supply chains seized up and tourism slumped. And, just as they were making a tentative recovery, Russia’s invasion of Ukraine in February led to a spike in fuel and food prices; central banks subsequently tightened policy to tackle rising inflation. Foreign investors withdrew over $56 billion from emerging market bond funds over the first seven months of the year (although the rate of outflows eased somewhat in late July).2
Emerging markets should be more resilient than they were during the so-called Taper Tantrum of 2013
The impacts have diverged across emerging markets. Commodity exporters and countries with fiscal scope to shield restive populations from rising food and energy prices – such as larger Latin American economies – are in a stronger position than those in the immediate vicinity of the conflict in central and eastern Europe. Large commodity importers such as India, Turkey, and Egypt, along with more-indebted frontier market countries, could be particularly vulnerable as borrowing costs rise.
Overall, however, emerging markets should be more resilient than they were during the so-called Taper Tantrum of 2013, when the Federal Reserve signalled it would reduce its asset purchases, a move that prompted similar levels of capital flight. With some exceptions, current account balances are more favourable nine years on; many economies also have deeper, more liquid domestic markets, lessening their dependence on foreign capital.3
“Most emerging market nations are in better shape to weather higher rates than they were in the run-up to the Taper Tantrum. Specifically, current account balances are much healthier, as are the level of foreign exchange reserves that can act as buffers as US liquidity conditions tighten,” says Nafez Zouk, emerging market sovereign analyst at Aviva Investors.
Improving corporate fundamentals
Emerging market companies are also a very different position than in 2013. One of the key stories of the last decade has been the ascent of innovative firms that have expanded beyond their domestic markets to wield clout on the global stage, such as Chinese tech giant Alibaba or Indian telecommunications company Reliance Jio. Issuance of emerging market corporate bonds has risen sharply; the market has grown much faster than developed market equivalents (see Figure 1).
Figure 1: Growth of EM corporate bond issuance versus other debt markets
Source: BAML, June 2022
More pertinently, emerging market companies have also strengthened their balance sheets over this period. Leverage among emerging market companies is at its lowest level for ten years – and far below the average among US firms – while the interest coverage ratio, a measure of a company’s ability to service its debts, is at its highest level since 2012 (see Figures 2-4). During previous episodes of turmoil, overly leveraged emerging market companies had few buffers to absorb a slowdown and an associated decline in earnings; today, the picture is much more positive.
Figure 2: Net leverage of EM corporates versus US corporates (x)
Figure 3: Interest coverage of EM corporates versus US corporates (x)
Figure 4: Cash-to-debt positions of EM corporates versus US corporates (per cent)
Source: BAML, June 2022
These improving fundamentals are reflected in higher average credit ratings across the benchmark JPMorgan Corporate Emerging Markets Bond Index (CEMBI) than the sovereign-focused Emerging Market Bond Index (EMBI), at BBB- compared with BB+. This is partly due to CEMBI’s inclusion of investment-grade bonds from blue-chip companies in China, South Korea and Taiwan; the CEMBI features fewer high-yield issuers and fewer longer-duration bonds (which are more sensitive to rising rates) than the sovereign index.
The CEMBI tends to outperform the EMBI during periods of market stress
The CEMBI tends to outperform the EMBI during periods of market stress: data shows the corporate index is less sensitive to changes in US Treasury yields than the sovereign index (see Figure 5). Credit spreads among CEMBI oil and gas companies are also less sensitive to fluctuations in the oil price than their developed-market peers. This reflects the preponderance of national-champion energy firms in the index, which can count on implicit government support when commodity prices fall.4
Figure 5: Spread between EM corporate and sovereign debt widens (per cent spread of 10-year US Treasury)
Source: J.P. Morgan, June 30, 20225
Nevertheless, the market remains inefficient, and strong fundamentals are not always reflected in pricing. As a result, emerging market credit continues to offer value over both sovereign debt and developed market peers, Kam argues.
“Although fundamentals have improved, there are still pricing dislocations. Good emerging market companies still have to pay a pickup over developed market equivalents. And sentiment on emerging market companies continues to be affected by sovereign risk, notwithstanding the fundamental strengths of the issuer. These inefficiencies can be exploited by investors with the knowhow to navigate a broad and diverse market,” she says.
Be selective
There are risks, however. One key concern is the economic impact of China’s zero-COVID policy. Swiss investment bank UBS recently forecast China’s GDP would grow at three per cent in 2022 – lagging its target of 5.5 per cent – as lasting COVID restrictions and a lack of clarity on an exit strategy dampen corporate and consumer confidence.6 Indebtedness remains an issue in the Chinese property sector and among local government financing vehicles (LGFVs) – investment companies that finance infrastructure and real estate projects on behalf of local governments.
Kam says while the portfolios she helps oversee are overweight Chinese corporate debt, the holdings are concentrated in a small number of less heavily indebted sectors that are best able to withstand a tougher economic climate: either debt issued by companies with strong fundamentals or by strategically important state-owned enterprises.
Outflows of foreign capital remain an issue for sovereign and corporate issuers
Across the wider market, outflows of foreign capital remain an issue for sovereign and corporate issuers as the uncertain macroeconomic outlook weighs on sentiment. However, many emerging market companies proactively refinanced their debts in 2021 when interest rates were lower, meaning they have less need to tap international markets now (see Figure 6). This partly explains the slowdown in emerging market corporate debt issuance, which was $159 billion over the first six months of 2022, less than half of the total issuance of $537 billion in 2021.7
Figure 6. EM corporate bond issuance (US$bn)
Source: J.P. Morgan, July 1, 20228
Emerging market commodity exporters, in particular, have shown disciplined liability management over recent years. As well as refinancing debt at affordable rates, many firms have opted to use the proceeds from high commodity prices to reduce overall debt levels rather than to pursue mergers and acquisitions or pay out higher dividends to shareholders.
“The starting point for corporates coming into this crisis was relatively strong compared to sovereigns,” says Aaron Grehan, head of hard-currency emerging market debt at Aviva Investors. “It’s worth noting commodity exporters form a reasonable part of the corporate market. We have seen an improvement there, with decent results from the majority of companies, although some will be impacted by slowing economic growth.
“Whenever there are signs of stress, that’s generally when you’re presented with opportunities. It’s about understanding those risks and how they will impact countries and companies. When I look back over the past ten years, our best and biggest opportunities have come from picking the winners or names relatively better off during periods of challenge,” Grehan adds.
He emphasises the need for debt investors to be selective, considering geographic and sector information and undertaking rigorous bottom-up, fundamental research that incorporates environmental, social and governance (ESG) metrics.
According to JP Morgan estimates, default rates for the overall CEMBI universe could be as high as 10.7 per cent in 2022. But, illustrating Grehan’s point about the need to be selective, that headline figure masks significant dispersion across regions. Excluding China (specifically its problematic property sector), Russia and Ukraine, JP Morgan forecasts the CEMBI default rate to end the year at 1.5 per cent; currently, year-to-date defaults for Middle Eastern and Latin American corporates in the index are running at zero and one per cent, respectively.
Resilient companies
Companies with continued access to financing, a proven track record of earnings growth and declining leverage look best placed to stay resilient.
Based on these criteria, certain companies and sectors stand out. Benefiting from elevated commodity prices and low leverage, energy firms have been among the better performers in 2022. Looking ahead, debt investors should focus on companies that can access liquidity from alternative funding sources, such as bank loans or local-currency bonds. This may prove a key advantage if conditions worsen.
“Understanding a company’s access to liquidity is an important consideration when analysing the relative strength of corporates. When the primary market is closed, they are more reliant on alternative funding sources of financing such as bank debt or local-currency bonds,” says Devin Cameron, corporate analyst, emerging market debt at Aviva Investors.
Cameron cites Indonesia’s MedcoEnergi as a company that retains such options. As the country’s largest domestic supplier of natural gas, it is strategically important, boasting strong relationships with local and international banks. Additionally, Medco has actively tapped Indonesia’s relatively deep local markets.9
Access to funding is also an important consideration in the emerging market financial sector, where banks have come under pressure to adjust their business models and prioritise liquidity preservation over profitability in recent months. High-quality banks with local-market funding options that can be accessed when international financing becomes trickier – such as Banco de Brasil and Mexico’s BBVA Bancomer – look to have relatively stronger prospects.
“Our focus remains on large, high-quality bank names with ample capital and liquidity reinforced by deep local market funding alternatives, such as those in Brazil, Mexico and South Africa,” says John Wright, financials credit analyst at Aviva Investors.
We see particular value in the subordinated debt instruments from the best-in-class names
“While the next six-to-12 months are likely to remain challenging, we expect the higher interest-rate regime and ongoing digitalisation of banking services to ultimately support both higher net-interest margins and profitability among these institutions. As such, we see particular value in subordinated debt instruments from the best-in-class names,” Wright adds.
Structural growth
Elsewhere, companies that specialise in building and leasing telecommunications infrastructure in developing economies could offer opportunities for investors with an eye on short-term resilience and long-run profitability. These firms tend to present high, stable margins and long-term contracted revenues, providing visibility into future earnings.
One example is IHS Towers, a telecoms company founded in Lagos that now has operations across Africa, Latin America and the Middle East. The firm has long-term contracts with mobile network operators; importantly, these contracts are denominated in hard currency and inflation-linked, which means IHS should be able to pass on cost increases to offset pricing pressures.
Tech-savvy populations are propelling strong data usage growth in as-yet underpenetrated markets across Africa and the Middle East
Longer-term demographic trends are also in the company’s favour: young, tech-savvy populations are propelling strong data usage growth in as-yet underpenetrated markets across Africa and the Middle East. This speaks to a broader point about emerging market companies during a turbulent period: they appear to be well positioned to benefit from secular growth over the coming years.
The IMF’s global economic outlook, published in July 2022, forecasts GDP growth of 6.8 per cent across emerging economies this year, outstripping the 5.2 per cent rate among advanced economies.10 And while growth is expected to slow to 3.6 per cent in 2023 and 3.9 per cent in 2024, these figures still comfortably exceed the expectations for developed economies (see Figure 7).
Figure 7: IMF growth outlook
Source: International Monetary Fund, July 202211
Emerging market companies with good fundamentals should be able to stay resilient in the face of economic growth challenges. And the vast size of the emerging market corporate debt universe, with its range of issuers across multiple sectors and geographies, gives investors the benefit of choice.
“Over the longer term, emerging markets have far greater structural growth potential than developed markets, as high-growth tech and digital sectors start to play a bigger role in these economies. This could help investors deal with an environment of longer-term structural inflation,” says Kam. “For now, while waiting for clear signs of a broad-based rebound, we are focusing on bottom-up credit stories in emerging markets. The breadth and depth of these credit markets means there is plenty of scope to find resilient companies.”
