EM Debt in 2022: China, COVID & Central Banks

Omotunde Lawal: The other thing that people who are thinking about investing in the asset class should be thinking about is certainly ESG. I think that's going to be an even bigger part of our asset class for this year. I mean, last year we had over $100 billion of supply of ESG bonds. This is coming up just $40 billion in 2020, so I expect this year to be an even bigger jump. And I think the big thing now is everyone's now quite comfortable with ESG analysis and integrating ESG into the funds. And now it's really where potential investors will be taking a look under the hood to really see just how green a lot of the credentials of these ESG bonds are.

Greg Campion: That was Omotunde Lawal, Head of Emerging Markets Corporate Debt at Barings. And this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion. And today we are going deep on emerging markets deck. The conversation that follows with Omotunde Lawal is really a crash course in the outlook for EMD in 2022. We discuss us why the asset class underperformed last year, how omicron is impacting the outlook, why the path for China has become much less clear, and where the team is seeing the most value today. So without further ado, let's get into it. Please enjoy this conversation with Omotunde Lawal. All right. Tunde Lawal, thank you so much for joining me from London today.

Omotunde Lawal: Thank you, Greg, for having me again.

Greg Campion: I am excited to have you again. You're a multi- time guest here on Streaming Income, and there's a reason why we keep coming back to you. It's because we get so many great insights from you. So we're talking about EM debt today, and I want to spend the bulk of this conversation talking about what's next, what's lies ahead in 2022. But maybe before we look forward, we can look back. So if you wouldn't mind just giving us a refresh on how emerging markets performed last year, 2021. I know it was a bit of a more difficult year probably than usual, but what really drove performance and got us to where we are today?

Omotunde Lawal: So 2021 will definitely go down in history for me as one of the most eventful years in the asset class to date. I mean, there was no shortage of surprises. We kicked off the year, quite early on with volatility in Turkey with President Erdoğan abruptly firing the central bank governor on a Friday night in April. And from there on, we came into the office on the Monday to face huge amounts of volatility in Turkey. And then we had elections in Peru where you had a very radical candidate who ascended to the presidential seat. You had a constitutional referendum in Chile, you had the downgrade of Columbia to high yield. You had volatility in Brazil during the year from Lula being released from jail, with his conviction being overturned and the likelihood that he could become the next Brazilian president. And then you had the huge amounts of volatility in China. I mean, where do we begin from with the China volatility last year? It came through in all manners, all sectors, nobody was spared. It went through the TMT sector, the education sector, the consumer sector, but it was the real estate sector that really felt the brunt of it. And that's been going on with a doubling down by the government of trying to reduced leverage within the sector. And that's been causing a liquidity crunch in that system since about July, which culminated in the largest default that's happened for the Chinese high yield issuer, which was Evergrande. Evergrande is the largest privately on real estate company. It defaulted officially in December after having sort of limped along through September using grace periods on its debt. So there was no shortage of volatility. And of course, right, right at the end of the year you had Turkey coming back for a part two where the Turkish lira actually went to a high of almost 18 right before Christmas. So EM participants, I think, EM investors have had a very eventful ride in 2021.

Greg Campion: You earned your Christmas break this year, that's fair to say.

Omotunde Lawal: crosstalk I certainly felt I needed it by the time it came around.

Greg Campion: Yeah. Yeah. So that's obviously a tremendous amount of activity to follow and to try to navigate through from an investment portfolio standpoint. And of course with the context behind all of that of the world still dealing with a global pandemic. And so maybe that's where I'd like to go next is to talk a little bit about how EMs are handling the pandemic, whether that's different from DMs or not. So where are we today from a pandemic standpoint when it comes to emerging markets?

Omotunde Lawal: So I think 2022 is really the year where we see more progress in terms of emerging market vaccination programs and booster programs. And I think that's sort of going to help shape how the reactions to omicron and any other variants that come through in 2022. as far as it relates to omicron specifically, we haven't really seen, apart from China, which is operating a zero COVID policy, most of the other EMs are being quite measured in their approach so far. They're using a combination of curfews, restrictions after certain time of day, and quarantine rules to sort of manage the omicron spread so far.

Greg Campion: And are you seeing still a big impact when it comes to travel and tourism? I know that can be a pretty big industry depending on the market that you're talking about.

Omotunde Lawal: Yeah. So for EM I think, apart from China and Hong Kong, where it's really hard in terms of they're maintaining strict border controls, what we're seeing is a lot of the other countries subject to testing requirements and quarantine rules and things like that. A lot of EM countries remain open for business. The big tourist places like Thailand, for example, at some point during 2021, they did reopen the borders to tourists and scrapped the need for quarantines. Although quite recently, they've brought that back because of omicron, in terms of quarantine and rules. But still in Phuket you could still go there. So there are countries that you can go, people are still moving around, it's just subject to some restrictions.

Greg Campion: You mentioned China and their zero COVID policy. Let's talk a little bit about China because it's such an important component of the picture for emerging markets any year, but it feels like maybe even more so this year. And I know there's both things that are positive and giving you a little more hope that things could improve going forward, and there's things that are maybe holding back. So tell me about how the team is assessing the economic outlook for China at this point.

Omotunde Lawal: I'd say following on from the earlier comment that China obviously caused a huge amount of volatility last year, there seems to be some sort of change or reform underfoot in China, which has seen a series of regulatory crackdowns on certain sectors and just a slight shift in where the policy priorities lie. We saw that kickoff some point at the start of the year with Alibaba and the fines that were imposed on them. And that sort of gave way to a bigger antitrust investigation and cracked down on the tech sector. That then migrated further into the property sector which had already seen some tightening measures, and that sort of tightened further in the year. And then we saw the crackdown on consumer apps and data in that big war on big data between US and China, and then culminated in the crackdown on the education sector right about July. And then since then, we've continued to see that headline noise through China as the property sectors, liquidity crunch has reverberated through the economy and led to a much larger slow down, as it were. And that seems to have continued more into 2022. I think the previous thesis around China was there would always be growth of some sort and they would always do what it took to generate that growth, but it certainly seems that the priority has changed and they've de emphasize that growth at the sake of growth. And it seems the emphasis is now really about the quality that growth. And so we are seeing that historical sectors like real estate, where it is the engine of growth. I mean, it contributes about 28% of GDP growth and about 26% of urban employment. That typically would've been the engine to go to to stimulate growth, but it seems that the government is quite reluctant to use that tool. And if anything, they seem to be trying to deleverage that sector particularly. And so that's causing a bit more of a drag to growth expectations for China with... I think the base case out there is China potentially grows 5% in 2022 with a lot of sell- side analysts suggesting that probably is going to grow a lot lower than that.

Greg Campion: So that's a really interesting inflection point, potentially. So if you think that is the case and you think maybe there's been a transition from growth at all costs, to use a kind of blunt phrase, to as you say more focused on the quality of the growth. As a long term debt investor, whether you're talking about corporates, sovereigns, any of the EM debt, investment avenues, is that a good thing or is that a bad thing?

Omotunde Lawal: Well, it depends how you look at it. I think from the overall perspective of how China is linked to the rest of EM and the rest of the world, a pronounced or a bigger than expected slow down in China certainly reverberates around the rest of the world. China is a big consumer of commodities and about a third of the commodity demand in China is consumed within the real estate sector. So if you have a real estate sector that's going to be down 10, 15% in a hypothetical scenario, that has a knock on impact on commodity demand, which ergo has a knock on impact on other economies. And then this zero COVID policy that they are operating as well, that has some impact on production, which has some impact on inflationary pressures as well. So there are all these consequences to think about it in terms of China, but them focusing more on the quality of growth aspect of things, I'd say that as a long term investor, yes, the leveraging and the crackdowns that are going on at the moment is very painful. However, I still remain anchored around the fact that the real estate sector in itself is very strategic to the economy and it's unlikely they would allow it to implode. And so, yes, there will have to be a culling of the weak segments of that sector, but you should have some survivors. And those survivors in my view, in the longer term, you would be in a better position investing in those survivors. And so that's really the focus of the team is really focusing on identifying who the likely survivors would be in that sector, because the sector has a need to exist. And it's extremely strategic.

Greg Campion: So perhaps some short term pain for investors as China shifts more towards this longer term focus on this more sustainable growth path. But I think that makes a lot of sense in terms of what you said as investors trying to pick the long term winners and the long term survivors in this space.

Omotunde Lawal: I just might add there I think the other thing is I think that the market is also grappling with looking back to history for data points and clues as to how the Chinese government's reaction will be in the current environment. And I think historically when you've seen this sort of bouts of leveraging, we've expected a policy response a lot sooner. And this time around the policy response has taken a little bit longer to come through. And I think that's where you are then getting a loss of market confidence and the elevated risk that is there a policy error risk in China as well. But again, you have to come back to the fundamentals and you have to come back to the data about the sector itself, how strategic it is and what the biggest systemic risks they would be running would be with that sector.

Greg Campion: That's a really great point. Coming back to the fundamentals, and I know that that's what your team is doing every day. So I think that makes a lot of sense. How about if we look more broadly outside of China and we look at the rest of the EMD world? So we've got, we've talked about China, we've talked a little bit about the state of the pandemic. Obviously we've got some other big forces going on in terms of inflation has really picked up, especially notable in developed markets like the US where we just recently printed a 7% CPI number. So we've got that. We've go the Fed under a lot of pressure to raise rates. So within the context of all this stuff, plus a number of the geopolitical risks, of course, that you mentioned up front. Within the context of all of that, what is looking attractive to you today across the EM universe? And I know that obviously your specialty is EM corporate, so I'd love to hear you talk about that. But maybe even if you could mention some of the parts of the sovereign and local universes that we like or don't like today. That would be great to hear.

Omotunde Lawal: Okay. So good question. In the context of rates going up in the US and the inflation which has been foremost in everyone's mind, I mean every single conversation everyone has is about inflation, EMs have been... They just like the developed markets are sort of seeing high inflation pressures as well. No doubt. And you're seeing EM central banks have been responding, at least since 2021 have been hiking rates. You've seen a lot of the EM central banks. The most aggressive has been Brazil so far where in 2021, they hiked multiple times trying to sort of keep it on top of the inflationary pressure using Mexico hike. Most of the Latin economies, the Asian economies, all hiking. Chile hiked, I think yesterday, Korea is hiking. So all the EM central banks have been hiking. So it was sort of preempting the Fed move as well. So there's been a bit of cushion built in there against those inflationary pressures within EM. In terms of the corporate specifically, yes we are starting to see comment out of the issuers, especially in the third to fourth quarter of 2021, talking about higher inflation pressures. But by and large the EM corporate universe that we speak to, they seem quite sanguine about their ability to pass through price increases to recoup this higher cost pressures that they see. Some of them expect that they will have the ability to cut costs within their cost base to absorb some of these inflationary impact. So it seems to be a bit of a mixed bag depending on what sector that you speak to. But again, I think everyone again talks about yes inflation has gone up, but the expectation also that in the second half of the year, hopefully with base effects, we should start to see inflation pressures ease somewhat. Some of the supply chain blockages that we had from last year in terms of the chip shortages should abate somewhat. Some of the supply disruptions that we had around some of the commodities should abate somewhat as well. So we're expecting that perhaps some of those inflationary pressures should sort of ease off a bit in the second half of the year, in addition to the fact that the corporate issuers should be able to increase prices to absorb this.

Greg Campion: Now on that corporate side, are there parts of the rating spectrum that are more attractive or less attractive to you today?

Omotunde Lawal: Yes. In a rising rate environment, yes we do like pockets of EM I think, especially within EM corporates. It's an asset class that structurally has much shorter duration anyway. It's a four and a half year duration asset class. And so within that, the preference in a rising rate environment is in the high yield segment of that market, which is running about four years duration. And then you've got short duration products within that subset, which can give you even shorter duration profile. And then in terms of things that we like given the current contracts of the US and the current market environment, I think the commodity sectors and the cyclical sectors are still segments that we like from a sector perspective. And that's because commodity prices remain at historically elevated levels anyway. Albeit at lower levels than 2021, but still higher than historical levels. So still quite attractive, similarly for the cyclical sectors. I'd say also the TMT sector, the tech sector. I think that's a sector that we like also particularly at the moment, given the technological advancements and the hybrid working from home that everyone's doing globally as well. And then obviously from a country perspective as well, there are certain countries that we do like, because they've got that exposure to the commodities. I think countries like Ghana, where we've got commodity issuers that we can pick from, we do like those. We've got some of the frontier countries as well like Uzbekistan, Georgia, where they're more idiosyncratic stories for us to get comfortable with and get our teeth stuck into. And then places where we're watching for value to appear later in the year would be places like Turkey, where it does seem like events potentially need to get worse before they get better. And potentially when they happens, you should get a better opportunity to take a look. Same thing with China real estate. I think potentially until you get that sort of policy response or a firmer policy response I think, then there's opportunities to take a look at potentially opportunities there as well. And then places where we are watching are places like Brazil, where they've got the elections later this year in October. Being a bit cautious about how much risk we're taking in Brazil going into those elections. And then being quite cognizant of the geopolitical risk that you mentioned earlier in places like Ukraine and Russia in terms of position sizing and exposure and what sectors you're taking exposure to as well.

Greg Campion: And in terms of defaults, so you mentioned the China property sector earlier, which obviously has had some high profile defaults. But if you look beyond that, if you look at the EM corporate universe overall, what are defaults looking like? And then also related to that, do you feel like the yield premium that you're earning on average in EM corporate debt relative to developed markets is compensating for any risk on that side?

Omotunde Lawal: Interestingly, actually. EM corporate default rates in 2020 were only 3. 5%. So nowhere near the double digit numbers that anybody assumed at the start of the pandemic. And then in 2021 it was on a really decent track to be below 2% until the China volatility happened. And so we finished the year with default rates in the double digits. But ex- China actually default rates were 1. 9%. So you can see that difference. I think in the China property sector we had about 16 defaults in 2021. And so that really pushed the default rates up.

Greg Campion: So really heavily concentrated there. But outside of that, it was pretty stable environment.

Omotunde Lawal: Correct. Outside of that, it was quite stable. And then the expectation for this year, I think it potentially depends on how the China property sector situation evolves. I think you've potentially got a few more default candidates to come through, especially in Q1, because there's a bit of a pressure in terms of timing of people before the Chinese New Year. And so that could cause an additional strain in the ongoing liquidity strain in China. And so potentially a few more defaults. But again, I'm expecting overall default rates ex- China to stay very manageable and below the 3% level, all things equal with no Ukraine invasion and no other unexpected events.

Greg Campion: All those wild cards.

Omotunde Lawal: Exactly.

Greg Campion: And then how about compared to developed market then? So if you're looking at high yield issuers in emerging markets versus high yield issuers let's say in the US, what does that kind of spread differential look like? And do you feel like that's... I'm curious where that is relative to history.

Omotunde Lawal: Right. So at the moment we're sort of a ballpark about a hundred basis points pick up in terms of spread, EM high yield versus US high yield. I think that kind of compares to historical levels around the 40 basis points level. So you're still at elevated levels. And that's factoring in a few of the idiosyncratic events that I mentioned that happened last year with Ukraine, with Brazil, with Turkey and China and with all these other places. And so that's where we are. From a overall spread perspective we're still probably around a hundred basis points, give or take, above the previous lows for the asset class. So the previous lows for the asset class we hit were in first quarter of 2018. And right now we're still about a hundred basis points above that. So there's potentially within itself as an asset class there's still spread compression potential against where we historically and then against developed markets as well. And then when you look within the asset class in terms of IG versus high yield, again, the IG portion of the market in terms of spread pickup to the US IG is probably somewhere around the 20 basis points range. Which is again slightly above historical averages. And when you look at the basis between EM high yield to EM IG, that's still at elevated levels as well. I think historically pre pandemic that differential was somewhere in the low three hundreds type level, and we're a little bit above that now. So that shows you that the high yield segment of our market is cheaper than the IG segment. And then the high yield certainly screening cheaper to developed market peers and against its own historical levels.

Greg Campion: That's a really helpful context. So it's defaults seem like they're pretty manageable, especially outside of the really concentrated area of China property, and then spreads are offering you more of a premium than you've seen.

Omotunde Lawal: I think one of the conversations that we've been having though this year, in terms of EM versus DM has certainly been around what's the risk to the asset class if rates go up in the US more aggressively than the market is expecting. And in that scenario, I think the concern is that you could see outflows out of our asset class and negative impact for the asset class. So that's certainly a risk to be aware of is that rising rate environment, especially in the US definitely does put pressure on EM as an asset class. But there are things to consider that in my mind mitigate some of that concern. And one of the big things is it's unlikely that we get a repeat of the 2013 taper tantrum for a few different reasons. I think starting point for sovereign and corporate balance sheets it's a lot healthier. The corporates are starting with much lower levels of leverage and much high levels of cash. Similarly, on the sovereign side, current account balances are a lot healthier. So I think the worry that you get that sort of huge outflow out of EM just because rates are going up in the US isn't quite there to the same extent. I would also say that this rate rise cycle has been well telegraphed for so long as well. And so you've seen that the corporates and the sovereigns actually had a huge amount of time to get their refinancing in order. You've seen huge amount of refinancing over the last two years when rates were low, where a lot of the corporates specifically they've locked in much cheaper funding costs. One of the TMT companies from one of the frontier countries in Eastern Europe, they originally came with a bond that had an 11% coupon. They've come back to the market looking to reprint a similar size bond deal, actually up sized by a hundred million dollars. And they're potentially going to pay something with a six handle. So that's going to be almost 500 basis points of coupon savings. So that in itself provides a cushion for them. And lots of different issuers like that. I mean last year, for example, was a record year of supply. We had 530 billion of supply last year alone. So it's been a huge amount of refinancing. So this cushion built into funding costs, a lot of funding has already happened, higher cash balances. And so yes, there is a concern for the asset class with rates going up in the US, but there are some things to consider that upset that.

Greg Campion: And to your point earlier, the duration of certain segments of the EM universe is significantly lower than some of the comparatives in developed markets. I mean, I know that you manage a short duration EM strategy. So that would be probably a perfect example.

Omotunde Lawal: Correct. And that gives you three years of duration or less in an asset class which is tilted to EM high yield. And average coupons within that segment of our market is mid single digits to 6. 5%. So you're getting exposure to something that's giving you a pretty decent cushion against rate rises, but the good carry that you're going to get not as sensitive to rates as a longer duration product.

Greg Campion: Makes sense. All right, Tunde. To wrap up our conversation, I just wanted to ask you what you think is next. So if you look out over the course of 2022, we've obviously talked about a lot of things. China, COVID, rates, inflation, et cetera. What would you be advising investors in the asset class or those considering an allocation to the asset class? What would you be advising them to keep their eye on in the coming year?

Omotunde Lawal: Everyone's eyes are on the Fed. So that's number one priority for us or especially fixed income investors. I'd say anyone considering an investment in the asset class, definitely thinking and having an idea of where the likely Fed rates rise trajectory goes to and inflationary pressures as well. That's a big thing. Is inflation going to be persistent or is it actually going to recede in the second half of the year? Is it transitory through the second half of or not? And how are inflation expectations anchored? Are people thinking that the Fed is going to potentially be behind the curve and expectations rapidly get away from them? The other thing that people who are thinking about investing in the asset class should be thinking about is certainly ESG. I think that's going to be an even bigger a part of our asset class for this year. I mean, last year we had over a hundred billion of supply of ESG bonds. This is coming up from just 40 billion in 2020. So I expect this year to be an even bigger jump. And I think that's the big thing now is everyone's now quite comfortable with ESG analysis in integrating ESG into the funds. And now it's really where potential investors will be taking a look under the hood to really see just how green a lot of the credentials of these ESG bonds are.

Greg Campion: Yeah, that makes sense. Okay. So we'll watch the Fed and we'll watch the continued proliferation of ESG. And I think your team has been at the forefront in terms of sharing some great thought leadership on that subject. So if you haven't read any of the papers that Tunde and the rest of the EM team at Barings have written, go to barings. com under the Viewpoints section and check that out. You've written extensively on your process and in the way that you're thinking about ESG.

Omotunde Lawal: One more thing to add in terms of investors thinking about the asset classes, obviously election cycles and things coming up within EM this year.

Greg Campion: Yes.

Omotunde Lawal: Brazil is a big market within EM and they've got elections this year. So that's something we're definitely watching out for. And then you've got a new president in Chile, potentially keep been an eye on how things develop from that perspective as well. And then obviously Russia, Ukraine, depending on how things evolve there. And then just keeping an eye on the knock on impacts of the continued inflationary pressure. Does that bring more social unrest vis- à-vis what happened in Kazakhstan earlier in the year? So these are the kind of things to have at the back of your mind as a potential investor in the asset class.

Greg Campion: Okay. So a lot to keep an eye on here. Tunde, thank you so much for this update on emerging markets today. I look forward to catching up with you maybe a little bit later in the year and in seeing how things have progressed.

Omotunde Lawal: Thank you for having me, Greg.

Greg Campion: Thanks for listening to Episode Number One of Season Six of Streaming Income. If you'd like to stay up to date on our latest thoughts on asset classes ranging from high yield and private credit to real estate and emerging markets, make sure to follow us and leave a view on your favorite podcast platform. We are on Apple Podcasts, Spotify, Google Podcasts and more. We publish a new episode every other week. And if you have specific feedback, you can email us podcast @ barings. com. That's podcast at B- A- R- I- N- G- S. com. Thanks again for listening.