Indrani De, Sandrine Soubeyran and Zhaoyi Yang, Global Investment Research at FTSE Russell
EM and US high yield credits have come under increasing pressure in the last twelve months, especially in Q2 2022, as hawkish shifts by central banks and growing concerns about the outlook for the global economy have weighed on appetite for “risky” assets generally. As can be seen in Chart 1, both EM high yield and US high yield (HY) credit spreads have almost doubled in the last year; EM HY spreads have widened from 497bp to 933bp, while those for US HY have risen from 322bp to 588bp. However, the higher quality EM and US investment grade corporates have stayed relatively stable, with spreads rising only modestly during the same period (Chart 1).
Also worth noting is that unlike in the last episode of Fed policy tightening in 2015-2016, this time the increase in EM HY spreads has been much more pronounced than for US HY.
Latam and European EM economies under pressure
The reason for the heightened risk aversion is that central banks in Emerging Europe and Latin America have hiked rates aggressively, and earlier than the Fed and other developed economies, as soaring inflation has put their currencies under severe pressure. For example, Hungary’s central bank has raised its policy rate by a whopping 855bp in the last twelve months, only to be surpassed by Brazil (among the first to raise rates in 2021), with a 900bp increase over the same period. Poland raised its rates by 6.4%, while Mexico has stepped up the pace of tightening to 7.75% (Chart 2).
China sneezes, the rest of Asia catches a cold
By contrast, in emerging Asia, lower inflation has allowed central banks to tighten monetary policy much more gradually and the policy stance to remain more accommodative than elsewhere. China, which adopted a zero-Covid policy, has kept its monetary policy easy to address slowing growth. The world’s second-biggest economy expanded by a mere 0.4% year on year, in the three months to the end of June.
Reason for optimism?
The fact that policymakers in Latin America and Emerging Europe are at a much more advanced stage of their tightening cycles than those in Asia, or in developed markets for that matter, means that most of the likely rate hikes in their cycles have already been done.
Déjà vu?
In contrast to EM credits, emerging market government bonds have remained relatively resilient in the last twelve months, with 7-10-year EM sovereign spreads vs their US Treasury equivalents falling from about 300bp to below 200bp (see Chart 3).
But compared to 2015-2016, it is difficult to avoid posing the question as to whether history may be repeating itself, given similar trajectories in spread moves. Still, as Chart 3 shows, EM credit spreads were much more distressed in 2015-2016 than they have been in 2021-2022.
Chart 4 shows that similar to the US yield curve flattening, EM yield curves have also flattened since 2021, while the Chinese yield curve has remained stable. This highlights the differences in monetary policies between the US, China and other EM countries, where most EMs and US Fed are tightening, while China is easing (as data shows in Chart 2 on policy interest rate changes in the last twelve months). Moreover, the Chinese yield curve appears to be repeating a similar trajectory in 2021-2022 as in 2015-2018, during the last episode of Fed rate tightening.
Pressure on EM currencies
Finally, EM central banks such as in India, Thailand and Poland have all recently stepped up interventions in the foreign exchange market to support their currencies against the exceptionally strong US dollar. And while most major EMs have reduced borrowing in US dollars over the last twenty years, and are therefore in far stronger position, there are still a few pockets of concern where domestic currency weakness could cause balance sheet problems. Turkey and Sri Lanka stand out in this regard, as both of these countries have idiosyncratic reasons for their exceptionally weak currencies.
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