Scott explains why we have downgraded emerging market local debt to neutral even as its valuation has cheapened.
We see improving outlook for credit in general due to overwhelming policy action to limit the coronavirus shock and recent market selloffs. Yet we have turned more cautious on emerging market (EM) local debt despite depressed valuations after selloffs. Why? Currency is key. Some emerging economies have allowed their currencies to weaken to help absorb the economic shock. We see a risk of further currency declines in some emerging economies, and this could wipe out the relatively high coupon income from local debt. There are brighter spots in EM: We are still overweight equities and credit in Asia outside Japan, with China gradually restarting its economy and readying more policy support.
Emerging economies are different in economic fundamentals, fiscal conditions, governing capabilities – and the quality of public health systems. Compare key metrics on our interactive Emerging markets marker. Many EM currencies have fallen sharply against the U.S. dollar, such as the South African rand and Brazilian real. See the chart above. This follows a pattern seen in past crises, when countries with the greatest external vulnerabilities (current account deficits) have often taken the biggest hit to their currencies’ exchange rates. One difference from previous crisis periods: Many emerging economies today are not fighting currency declines, which act as economic relief valves that can increase export competitiveness and shrink current account deficits over time. Instead, they are easing monetary and fiscal policies. This comes with risks. Potential capital flight could exacerbate currency declines and force some EM central banks to reverse course and raise rates.