Emerging Market Debt Commentary – Q1 2022
The outbreak of the Russia-Ukraine War drove EM market turbulence in the quarter, with bonds of countries most impacted selling off. Returns varied, with sharp commodity price increases boosting the fortunes of some EM countries, particularly in Latin America, while parts of EM Asia grappled with tighter COVID-19 restrictions.
Emerging markets experienced a very turbulent start to the year as Russia invaded Ukraine towards end of February, taking markets by surprise. Significant penalties on Russia swiftly followed, most notably the sanctioning of the Central Bank of Russia (CBR) that prevented it accessing much of its offshore reserves. In addition, major Russian banks were cut from the SWIFT system, thereby stifling access to global capital markets. The Russian local bond market became practically inaccessible to foreign investors and ultimately led to the exclusion of Russian bonds from major fixed income indices (FTSE, JPMorgan, Bloomberg) from 31 March.
News flow around the war stoked a massive sell-off in Russian, Ukrainian and Belarusian local and hard currency bonds, with CEE (Central and Eastern Europe) markets and Turkey also impacted. In the initial weeks of March, the risk-off moves became broader across EM, mostly around supply-side concerns as Russia and Ukraine have outsized contributions to global trading in energy, wheat, and metals. These price moves and supply disruptions fueled increasing concerns about risks of a stagflationary environment developing, with EM growth forecasts revised down and inflation forecasts revised up.
In the final three weeks of the quarter, EM currencies and EM spreads stabilized somewhat to provide some respite, as differentiation in EM regions became more pronounced. In EMFX, against the backdrop of surging commodity prices, commodity exporters rallied and the sell-off was concentrated among countries that were more closely linked by proximity and other ties to the Russia-Ukraine War (see Figure 1). There was some underperformance in EM Asia on account of surging Omicron cases in China and its zero COVID policy that meant tighter restrictions on social mobility. In EM hard currency markets, a similar differentiation in spread changes was evident between commodity exporters and those having significant exposure to the war in Ukraine, and a few distressed countries (such as Pakistan, Tunisia etc.).
Meanwhile, surging inflation was a consistent theme through Q1 with the February US headline CPI rising by 7.9% year-on-year, a level not seen for almost 40 years. The US Federal Reserve delivered a 25 basis point (bps) rate hike in its March 15-16 meeting and, based on the implied rate hikes priced into Fed Funds futures, the policy rate is expected to reach 2.5% by end of 2022. Uncertainty around the economic outlook led to a flattening in the US Treasury yield curve throughout Q1, with the 2s10s spread narrowing to just 4 bps by quarter-end, down from 79 bps at the end of December. But with higher real rates (after EM inflation subsides) and EM central banks staying ahead of DM counterparts in terms of policy normalization, many EM countries seem reasonably well positioned to tackle domestic inflation and FX instability amid higher US rates. Over the course of the latest quarter, hard currency outflows totaled -$11.9bn, while local currency outflows amounted to -$2.2bn. (source: JP Morgan).
[1]Source: Bloomberg Finance LP as of 31 March 2022