Warren Hyland: «Three Supporting Factors For EM Credit»
By Warren Hyland, Portfolio Manager at Muzinich & Co.
We are at the beginning of what could be a new COVID-19 theme; with seasonal influenza on the horizon, there has been a rotation into the southern hemisphere out of the northern hemisphere.
There were outflows from Emerging Markets (EM) in the aftermath of the COVID-19 crisis, and a slight delay in recovery, but inflows have started coming back since mid-September. Three key variables, which all drive flows, have improved – growth, liquidity, and sentiment.
Large Portion of Growth From China
China is a major engine in the economy, and growth there is back above pre-Covid levels. If this continues, China will likely represent a large portion of global growth in 2021 in our opinion. We believe the knock-on effect will be, on both, the rest of the Asia region and commodities positive.
We expect growth to be tilted in favor of EM, as they are in general more manufacturing focussed, in comparison with developed markets (DM), with large and now struggling service sectors.
We have also seen enormous support from Central Banks and governments, and EM tends to do well in an environment of a large liquidity pool.
Positive Boost
After the victory of Joe Biden in the US elections, we are hopeful that there would be potentially fewer trade issues with EM then there has been the past few years, and more fiscal spending, a positive boost to sentiment. What the U.S. buy, EM produce, so spending there will most likely be beneficial to EM.
Furthermore, outflows experienced early on in the crisis were based on an assumption that the ability for EM to fund capital markets would dry up, which hasn’t happened. YTD EM has continued to supply liquidity, and by year-end, they should be in line with the three-year average, regardless of the crisis.
Corporate Credit Over Sovereign Credit
Higher debt levels are a natural side effect of the COVID-19 crisis, as working capital and lost revenue has been substituted with debt. EM in general did a lot less fiscal spending and borrowing than Western economies.
However, we remain cautious towards countries with pegged currencies and low foreign exchange reserves coverage. We prefer corporate credit over sovereign credit, as we expect corporate leverage to fall next year as revenue normalizes.
Willingness to Pay
Regarding debt sustainability, nominal growth for 2021 will likely be higher than the cost of funding, so we have little concern at the aggregate level. Key headlines to watch out for will be rating agencies' actions and government communication on willingness to pay.
On the rating side, everything remains pretty stable at present, but if growth disappoints in H1 (which is not our base case), downgrades could follow. There are a few sovereigns that have communicated their lack of willingness to pay their debts, and these are well flagged.
Good Investment Choices
Currently, defaults in EM are lower than those experienced in the U.S. What has defaulted was what was expected, although events of Q1/Q2 have accelerated it. There are also not many surprise defaults outside of the airline industry. Distress is normalizing in EM, at a rate only slightly elevated from the historic average.
If we assume the EM HY default rate for 2021 to be similar, we get a view of potential spread compression over the year, with a way to go before we reach fair spread valuations, in our view. It is, for this reason, we believe there is still good investment choices to be made in EM HY.
Judicious Stock And Sector Selection Are Key
In terms of a longer-term perspective, it is likely a «winter wave» of COVID-19 will affect the northern hemisphere, slowing down growth and primarily affecting the service sector, a DM focus rather than EM.
A lot of our positioning is based on the belief that central bank support will outlive COVID-19, so it would cause serious concern if fiscal measures are tightened sooner than COVID-19 growth slackens. Judicious stock and sector selection within key identified economies may prove crucial to navigating the upcoming few months.
Warren Hyland has been a portfolio manager for emerging markets at Muzinich & Co. since 2013. He has 20 years of corporate credit experience. Warren has a BSc in Mathematics for Business from the Middlesex University London and later received his MSc in Shipping Trade and Finance from the CASS Business School. He holds the Chartered Financial Analyst designation.
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