Emerging-Market Debt Outlook: Mixed Conditions in 2022

06 January 2022

5 min read

Adriaan du Toit| Director—Emerging Market Economic Research; Senior Economist—Africa

Christian DiClementi| Portfolio Manager—Emerging Market Debt

For emerging-market debt (EMD), 2022 is shaping up to be a contest of conflicting forces. Investors will need to pinpoint pockets of resilience among the many macroeconomic challenges facing the asset class.

Among the obstacles in this asset class: a negligible difference in the GDP growth of developed markets (DM) and emerging markets (EM) excluding China; persistent inflation; populist pressures; and moderate near-term growth for China. Among the opportunities: China’s long-term growth plan and less external vulnerability for EM countries.

What does this climate mean for EM investors? For now, hard-currency EMs—sovereign and corporate bonds alike—have more appeal than local-currency EMs. And selectivity is key. Here’s why.

Obstacles: Emerging Markets Lose Their Growth Edge

As economies reopened in 2021, pent-up demand generated strong global growth. We expect more of the same for 2022. Strong global growth satisfies one criteria for strong EMD returns. But another key criteria for strong returns—that EM economies grow faster than DM economies—no longer holds. Instead, developed markets are now growing much faster than before the pandemic, while EM economies continue to chug along at their pre-pandemic pace. The result has been a narrowing of the gap between EM and DM growth (Display). Without a meaningful growth edge, EM has a harder time enticing investors into taking added risk.

Emerging Markets Have (Temporarily) Lost Their Growth Advantage

EM ex-China GDP normally grows faster than DM, but a DM growth surge in 2020 has erased that advantage—for now.

Current analysis does not guarantee future results.
As of December 31, 2021
Source: Haver Analytics and AllianceBernstein (AB)

What’s more, central bank rate hikes will likely slow EM growth. Inflation has remained higher and more persistent in EM, compelling most EM central banks to begin tightening monetary policy. We estimate that EM countries have completed less than half of their tightening cycle so far, leaving the lion’s share for 2022.

Slow vaccine rollouts across the emerging world are also challenging, and not only from the humanitarian perspective. Crises like the coronavirus pandemic intensify inequality and poverty, which could fuel public discontent and affect political and policy paths. Several emerging countries share features such as a young demographic that make them particularly vulnerable to populist pressures, delayed fiscal consolidation and eroded democratic standards. Investors should therefore take extra care when assessing countries facing elections in 2022—especially where socioeconomic conditions are fragile and economic scarring from COVID-19 is deep.

Finally, China’s growth has slowed, removing a historical tailwind for other EM countries. Pre-pandemic, China’s expansive growth drove commodity prices higher, which in turn helped drive growth in other commodity-rich countries. But China no longer sees itself as the world’s growth engine; instead, its broader policy framework prioritizes financial stability and the environment alongside growth. This has resulted in more realistic GDP growth targets, such as the 5%–5.5% target for 2022 (and in policymakers no longer having to drive higher-than-desirable growth in sectors such as property and manufacturing).

Opportunities: Green Economy to Fuel Demand for Commodities

China makes our list twice, as both an obstacle and an opportunity. That’s because the same policy framework that moderates overall growth also lowers the odds of a hard landing down the road. At any rate, China may no longer need to be the linchpin at the heart of a commodities surge. Over the next decade, the global drive toward net-zero carbon emissions will generate a huge increase in demand for copper, aluminum, cobalt and lithium—most of which come from EM countries—to upgrade electric power networks and make batteries. This strong demand is likely to fuel a commodities boom.

We also expect “just transition” financing—which looks to equitably distribute the costs of climate action—to supply large-scale multilateral support to developing nations for many years. For example, the recent United Nations Glasgow Climate Change Conference known as COP26 resulted in renewed pledges from developed countries to contribute at least US$100 billion annually to developing nations for transition financing, plus a deal to establish a centralized system for trading carbon offsets, with 5% of the proceeds earmarked for a climate adaptation fund for EM countries.

Meanwhile, EM countries’ external vulnerability has declined. Basic balances—the sum of current account balances and foreign direct investment—are as robust for EM countries as they’ve been in 20 years. A US$650 billion increase in the International Monetary Fund’s (IMF) Special Drawing Rights (SDR) to help countries deal with the ongoing impact of the pandemic has also improved EM external positioning. Further, an additional IMF facility in 2022 that transfers the benefits of SDRs from rich countries to developing nations would also strengthen EM liquidity.

Risk markets love a clear picture, but uncertainty isn’t behind us. Indeed, EMD and other risk assets took a hit in late 2021 as markets reacted to the rise of the COVID-19 Omicron variant, renewed travel restrictions globally and a more hawkish Fed. However, compared with 2020, there’s been a marked reduction in fear of unknowns. Case in point: the implications around Omicron remain unclear, but the size and duration of the market response suggests observers don’t expect it to have a durable economic or market impact in 2022. (We agree.) We expect uncertainty to lessen, but not disappear, as the world heads into an environment of above average growth and reduced stimulus.

Not All EMD Is Equal

Given this mix of obstacles and opportunities, we favor hard-currency sovereign and corporate debt. Hard-currency assets are less vulnerable to cyclical downturns, and high-yield spreads are relatively wide, with room for narrowing (Display).

EM High-Yield Spreads Are Wide Compared to US High Yield

Yield Spreads (Percent)

10-year graph of EM and US investment grade and high yield spreads. Only EM high-yield spreads offer current value.

Current analysis does not guarantee future results.
EM Corporates: J.P. Morgan Corporate Emerging Market Bond Index Broad Diversified High Grade. US Investment Grade: Bloomberg US Corporate Investment Grade Index. Global Corporate Agg: Bloomberg Global Agg – Corporate. EM High Yield: J.P. Morgan Emerging Market Bond Index Global Diversified High Yield.US High Yield: Bloomberg US Corporate High Yield Index.
As of December 31, 2021
Source: Bloomberg, J.P. Morgan and AllianceBernstein (AB)

In contrast, we remain cautious on local-currency assets over the near term, as these tend to bear the brunt in a sell-off. However, this sector may become more attractive later in 2022, once EM countries are further along in normalizing monetary policy and there is even more clarity around Fed tightening. Investors should closely monitor conditions and valuations and prepare to shift the portfolio mix as conditions warrant. It bears repeating: In this environment, selectivity is paramount.

That’s one reason we believe that evaluation of environmental, social and governance (ESG) considerations should be an integral part of the investing process, for both sovereign and corporate EM issuers. As implementation of COP26 pledges boosts commodity demand, we believe countries and companies who access those resources in the most environmentally friendly manner will have an advantage. And our research shows that about two-thirds of EM corporate bonds that underperformed over the past 10 years did so specifically because of ESG reasons, from catastrophic environmental events to accounting fraud.

On the flip side, companies with strong ESG practices should benefit from better financing terms, which strengthen an issuer’s balance sheet. Investors should therefore incorporate ESG factors into the analysis, even if responsible investing isn’t top of mind.

The bottom line? Heading into 2022, EMD investors should consider leaning into hard-currency sovereign and corporate EM debt, be selective about where to take idiosyncratic risk, and carefully weigh how ESG factors will affect their investments. Thorough research and an active approach to investing is key to mitigating risk and finding opportunities in EM, no matter which way the wind blows.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

About the Authors

Adriaan du Toit

Adriaan du Toit is a Senior Vice President and Senior Economist for Africa. He also leads AB's team of emerging-market economists. He joined AB in 2017 as a Sub-Saharan Africa economist. Prior to joining the firm, Du Toit was a Sub-Saharan Africa currency and rates strategist and director at Citigroup in Johannesburg, where he worked from 2013 to 2017. Between 2007 and 2013, he held three roles at Standard Bank in Johannesburg (rates analyst, head of Macro Research and fixed-income strategist). Du Toit started his career in 2004 as an economist at the South African Reserve Bank. He holds a BCom (Hons) in economics and an MCom in econometrics (cum laude), both from the University of Pretoria in South Africa, and an MSc in financial economics from the University of Oxford. Location: London

Christian DiClementi

Christian DiClementi is a Senior Vice President and Lead Emerging Market Debt Portfolio Manager at AB. He is also a member of the Global Fixed Income, Absolute Return and Income portfolio-management teams, and oversees emerging-market investments across AB’s suite of fixed-income products. DiClementi joined the firm in 2003. Prior to becoming a member of the Emerging Market Debt portfolio-management team in 2013, he served as a member of AB’s Economic Research Group, focusing mainly on sovereign fundamental research for the Caribbean, Central American and Latin American regions. Previously, DiClementi worked as an analyst in the firm’s Quantitative Research Group, with an emphasis on global sovereign return and risk modeling, and as an associate portfolio manager responsible for municipal bond portfolios. He holds a BS in mathematics (summa cum laude) from Fairfield University. Location: New York

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Emerging-Market Debt Outlook: Mixed Conditions in 2022

Obstacles: Emerging Markets Lose Their Growth Edge

Opportunities: Green Economy to Fuel Demand for Commodities

Not All EMD Is Equal

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