Despite strong year-to-date performance in what feels like a resilient market, seasoned EM sovereign credit investors are publicly emphasizing caution. They recognize that stretched valuations, described as a 'glass overflowing', and potential US recession risks create significant downside vulnerability.
Related Insights
A strategic divergence exists in EM corporate credit. Mandate-bound real money funds feel compelled to stay invested due to a lack of near-term negative catalysts, while more flexible hedge funds are actively taking short positions, betting that historically tight spreads will inevitably widen over the next 6-12 months.
A significant gap exists between optimistic market pricing and the cautious stance of credit rating agencies. While investors are rewarding frontier economies for recent reforms, agencies are waiting for a stronger, longer-term track record of fiscal discipline and stability before issuing upgrades, particularly in African nations.
While a stronger growth environment supports EM currencies, it is problematic for low-yielding EM government bonds. Their valuations were based on aggressive local central bank easing cycles which now have less scope to continue, especially with a potentially shallower Fed cutting cycle, making them vulnerable to a correction.
History shows that markets with a CAPE ratio above 30 combined with high-yield credit spreads below 3% precede periods of poor returns. This rare and dangerous combination was previously seen in 2000, 2007, and 2019, suggesting extreme caution is warranted for U.S. equities.
The surge in emerging market sovereign debt isn't uniform. It's heavily influenced by specific situations, such as Mexico issuing massive debt to back its state oil company, Pemex. Additionally, a notable increase in issuance from lower-rated 'Single B' sovereigns indicates renewed market access for riskier credits.
Investor appetite for emerging markets is in an ideal state: not euphoric, but recovering. Recent inflows of $25 billion are just a fraction of the $159 billion that flowed out over the previous 3.5 years, suggesting the recovery is in its early stages with substantial potential for further investment.
While overall EM credit spreads are near post-GFC tights, making value scarce, Argentina stands out. Following positive legislative election results, its sovereign debt has rallied significantly but remains wide compared to its own history and peer countries, suggesting substantial room for further performance in an otherwise expensive market.
Contrary to a simple narrative of improved market sentiment, EM sovereign resilience stemmed from unexpectedly strong macro fundamentals. Better-than-forecast current account balances, export performance, FDI, and portfolio inflows were the primary drivers of stability, exceeding even conservative projections from two years prior.
Despite compressed spreads and improved market access, credit markets are not complacent. Pricing for the most vulnerable emerging market sovereigns still implies a significant 17% near-term and 40% five-year probability of default. This is well above historical averages, signaling lingering investor caution and skepticism about long-term stability.
Despite being at historically tight levels, EM sovereign credit spreads are unlikely to widen significantly from an EM-specific slowdown. The catalyst for a major sell-off would have to be a 'beta move' originating from a crisis in core US markets, such as equities or corporate credit, given the current strength of EM fundamentals.