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A Market Head Fake While the Foundation Continues to Crack

The convergence of rising interest rates, high inflation and slowing growth have roiled global financial markets, including emerging markets (EM) debt. The Federal Reserve’s rate hikes are taking place against the backdrop of tightening by many central banks in developed and emerging markets. We believe these factors are fueling risk-off sentiment for EM fixed income assets. Despite a lower-than-expected US consumer price index (CPI) print in July and subsequent market rally, inflation prints continue to be stubbornly elevated and prices erratic. While the market indeed rallied, markets experienced a sharp selloff following the Fed’s 75 bps hike in September.

No place to shelter

Emerging markets debt declined during the third quarter with the J.P. Morgan EMB Hard Currency/Local Currency 50-50 Index returning -4.16% for the quarter ended September 30 and -19.34% for the year to date period. Other global indices also fell in the third quarter, including the Bloomberg Global-Aggregate Total Return Index Value Unhedged USD (-6.94%) and the J.P. Morgan EMBI Global Diversified Index (-4.57%). Spreads on emerging markets sovereign bonds widened about 22 basis points during the quarter, according to the EMBI Global Diversified Index. At the same time, the US dollar climbed and Treasurys slumped as investors focused on expectations the Fed will continue to deliver aggressive interest-rate hikes. The yield on the 10-year US Treasury note rose to end the quarter at 3.83% from 2.88% at the end of June.

During Q3, the Fed announced two rate hikes, both of which were 75bps, putting the Fed funds rate at a range of 3% to 3.25% and the highest level since before the 2008 financial crisis. Similarly, the ECB raised rates in July and September, taking its benchmark deposit rate to 0.75%. Financial turmoil in the UK also added to investor woes as the BOE launched an emergency intervention to restore order in bond markets after a government tax-cut plan sent borrowing costs soaring and triggered a meltdown in the domestic market.

Several EM central banks were particularly hawkish in Q3, including Hungary, Poland, Peru, Israel, Kenya, Ghana, Indonesia and South Korea. Policymakers in some developing countries are using high rates and reserves to defend their currencies against the rallying dollar.

The U.S. Strategic Petroleum Reserve (SPR) has sprung a leak!

From 1990 through 2021, the US SPR averaged 637m barrels in storage and it was rarely tapped into. In President Biden’s quest to lower fuel prices in the US, reserves have been drained by 34% through September 23, 2022, a level not realized since June 1984. This has aided in bringing the average price of gas in the US down 20% to $4.37/gallon from its peak in June. EM countries have reinstated fuel subsidies and some countries are facing recessions. Meanwhile, OPEC opted to cut production by 1+ mb/d in the third quarter to counter the fall in oil prices. As the northern hemisphere heads into winter, there are risks to the upside which may push prices higher from current levels. To add fuel to the inflation fire, Russia’s Nord Stream 1 and 2 were sabotaged, as delivery was shut off indefinitely in August due to equipment problems which disrupted gas delivery to Germany and Europe from that route. That said, some gas is still flowing from Russia through Ukraine and Turkey at reduced rates.  

Foreign bond markets—a trickle of issuance amidst strong outflows  

EM foreign currency bond issuance has been hit by surging borrowing costs, a strengthening dollar and shrinking global liquidity. New external debt issuance for 2022 slowed to $267 billion through September 30, lagging the pace set in 2021 and 2020 when full year debt issuance amounted to $718 billion and $752 billion, respectively, according to data compiled by Bank of America. The slow-issuance streak is expected to stretch into 2023 as governments and corporates wrestle with the higher yields demanded by global investors. The lack of financing will add pressure on governments that need to fund large deficits and is likely to result in more defaults. Sri Lanka recently defaulted, while Ghana and Pakistan are at risk and working with the IMF.

Investors withdrew another $22 billion from EM bond funds during Q3 and collectively have now pulled an estimated $70 billion from EM debt funds in 2022. This is the largest outflow from EMD since J.P. Morgan started tracking flows in 2006.

With Q3 2022 behind us, we have a conservative view toward investments as EM markets continue to face fierce headwinds.