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UBS AM: A gloomy year with scarce opportunities for emerging market debt?

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What will inflation, pandemic developments and global policy responses mean for emerging market fixed income (EM FX) as we move through the first quarter and beyond? That is the question the experts from UBS asset management are asking in the voluminous report 'Cross currents bring risks and opportunities’ Despite the gloomy outlook, they also identify some great opportunities for investors.

Global growth, global trade and commodity prices are amongst the most important global factors affecting EM economies and influencing EM asset prices, the experts say. “We expect 2022 to be mainly a carry year for EMFI, given the cross currents expressed above. This is not bad at all given the current low yield environment.”

According to the experts, sovereign (corporate) credit yields 5.5% (5.0%); local debt yields 6% and EM FX has an implied yield of 8%. If UST yields remain in the 1.5%- 2.25% range and spreads/rates remain unchanged then EM credit could end up returning a 4.5%-5.5%.

“However, there is ample scope for HY names to tighten in 2022, which would boost returns further. For example, China and Asia HY failed to deliver in Q4, but remain one of the most enticing opportunities in 2022. If China HY starts tightening in response to the measures announced and implemented by the authorities in December, this could have a positive influence not only in the whole Chinese complex, but also on Asia HY and EM HY in general.”

Regarding local bonds, the Fed is likely to begin its hiking cycle this year but the EM high yielders such as Brazil, where the terminal rate may exceed 12%, and Russia, where it may reach 9%, have room to cut rates when their inflation peaks, the experts say. “Low-yielders, particularly countries which haven’t even started hiking yet – for example, Asian countries such as India, Indonesia, Malaysia, Philippines, Thailand – may not be as lucky.”

As such, we believe that local bonds could offer enticing opportunities from Q2 onwards. “Regarding EMFX, value has been restored following the depreciations but more importantly the interest rates: Implied yields are now enticing and more in line with historical levels. For EMFX to unleash its potential, USD will have to depreciate, and UST will have to remain relatively stable.”

Highlights from the report:

  • The outlook for Q1 2022 is still cloudy, even though the entry level into the asset class has become attractive for both FX and yields.
  • Currencies are undervalued by historical standards, while advanced hiking cycles in many countries have restored yield support for currencies (particularly in Russia and Brazil).
  • We are only cautiously optimistic on the market given that the continuing disruptions from the COVID-19 pandemic and persistent global inflation create unexpected political slipovers.
  • Economic slowdown in China and the looming start of the rate hikes in the US are the main global headwinds for the beginning of the year.
  • We expect the main world economic centers to grow at a healthy pace in 2022, with lower/stable inflation (US, EU/ China) as the year goes by.

Here you'll find the complete report  ‘Cross currents bring risks and opportunities in 2022’ from UBS Asset Management.