Emerging markets have made better progress in tackling inflation than their developed peers and are now, for the most part, braced for a sharp downturn. That's according to participants at S&P Global Ratings' Global Emerging Markets conference in London on July 11, 2023.

While core inflation remains sticky, headline inflation has fallen across emerging markets, Paul Gruenwald, global chief economist at S&P Global Ratings told conference delegates. Central banks across emerging markets were quicker to respond to emerging inflation, so policy rates are believed to be at their peak, Gruenwald said.

"Average inflation across emerging Asia, excluding the Philippines, is expected to be within central bank targets by the end of 2023," Gruenwald said, "most others are likely to endure a bumpy ride and reach target by 2024."

The U.S. dollar index also appears to have peaked. "This is good for those with high U.S. dollar debt, those relying on inflows for financing, and those worried about importing inflation."

Growth in emerging market countries in Europe, the Middle East, and Africa (EMEA) and Latin America is expected to be well below long-term trends over the next 12 months. India and Southeast Asia will do better, but still not above trend.

External conditions will be tough, especially given an unambitious growth target coming out of China and growth in the advanced economies poised to sputter near recessionary conditions, if not outright recession.

Other in-house sector specialists and external guest speakers further reviewed the economic conditions emerging markets have navigated and discussed the outlook for these markets, which face common themes but have very individual challenges.

Bright Spots

Chinks of light are emerging in Latin America. "The Mexican Peso, the Brazilian Real, and the Colombian Peso are among the top-performing emerging markets currencies," Roberto Sifon-Arevalo, Global Head of Sovereign and MLI ratings, said.

Domestic demand in Mexico bucked the broader downward trend, Gruenwald said, adding that the country is benefitting from nearshoring. Central banks in Brazil and Chile could be the first to cut interest rates. "In addition, compared with other EMs these Latin American sovereigns offer relatively predictable policymaking a little geopolitical risk," Sifon-Arevalo said.

In EMEA, Poland's growth exceeded expectations. And, alongside fellow energy-intensive neighbor Hungary, its central bank could soon begin easing monetary policy, as lower energy prices alleviate inflationary pressures, despite very tight labor markets. Post elections, Turkish President Tayip Erdogan has installed a new economic team focused on how to cool down an overheated economy (and still-elevated inflation). The introduction of VAT has benefited the Gulf Cooperation Council region by bringing down the fiscal "break-even" oil price for the large exporters (the oil price at which general government budgets are in balance).

There are also positive developments coming from Africa. Kenya's domestic currency has improved, while Ghana has started the difficult progress of restructuring its commercial foreign debt in line with the objectives of its IMF program. Nigeria's new government has taken the encouraging steps of liberalizing its exchange rate regime and phasing out energy subsidies, which should ease fiscal and external pressures. Issues remain in its hydrocarbon sector, however, owing to impediments to raising oil production closer to its OPEC quota.

In Asia, economies with less exposure to global trade could have a lesser growth deceleration. While there has been a slowdown in Southeast Asia and India, growth in these areas remains "respectable" for 2023, according to Gruenwald.

Latent Risks

Emerging markets typically have a shorter maturity on their debt than developed economies, so the increased cost of borrowing is quicker to filter through.

"Governments have responded to recent crises by issuing more public debt, but this has become increasingly unaffordable meaning consolidation will likely be needed, against a backdrop of softening global growth," Frank Gill, senior director, Ratings Analytical, said. Nevertheless, this could also create opportunities for the private sector to replace the public sector as the key recipient of capital inflows from abroad, with more equity and less debt financing.

Eight sovereigns rated 'CCC' could join the three that have defaulted in the year to-date--Argentina, Mozambique, and El Salvador.

Across emerging EMEA, balance sheets suffered following demand and trade shocks. Fixed income curves are at an inflection point, leading to currency pressures. At a country level, Saudi Arabia's growth has declined due to reduced oil production, while South Africa's outlook remains dim as electricity supply and logistics issues are unresolved.

Ghana was forced to declare a debt payment moratorium after it was unable to refinance its debt in domestic markets. The administration completed a first-round domestic debt restructuring and is now in the process of re-negotiating its bilateral and commercial foreign currency debt. Positively, Kenya refinanced a big redemption due in 2024, while its domestic bond market remains deeper compared to most regional peers. However, modest net foreign currency (FX) reserves across sub-Saharan Africa (excluding Nigeria and Angola) remain a concern, while local FX demand remains elevated, even in Nigeria, where private sector arrears are substantial.

Asia Evolves

China + 1 has emerged as a key strategy. There is now much intra-Asia trade, tourism, nationalist economic policies, and nearshoring, motivated both by the competitive advantage offered, and positive geopolitical relations.

"China has lent more in the region than some multilateral banks, raising the question of whether this will become a cyclical trend. China's strategy appears to be to lift the region up, making its neighbors greater customers for its exports," Gregory Smith, emerging markets fund manager at M&G Investments said.

Reliance on the U.S. dollar has reduced, and neither Indonesia nor Malaysia are considered vulnerable to the currency. That said, it remains a dollar region. The Chinese renminbi has a gravitational pull on the region's other currencies, but it's not widely used to finance, and "investors want to know the dollar return on their investments," Kieran Curtis, portfolio manager, emerging market debt, at ABRDN, said.

India's path differs to the rest of Asia. "While there is some semiconductor manufacturing in the south, for example, it lacks the strategic infrastructure to really ramp up exports," said Natznet Tesfay, head of insights and analysis, economic and country risk, S&P Global Market Intelligence. "It is considered more outwardly focused than its neighbors, and it tends to move in concentric circles, first to its neighbors, then to its maritime neighbors."

Investment Opportunities

Emerging market financing conditions have tightened since early 2022 when inflation accelerated, and the Ukraine conflict began. These have recently stabilized but challenges remain, and higher interest rates will linger.

Over the past quarters we have seen a rapid and unprecedented global monetary tightening cycle, which has resulted in limited access to markets for speculative-grade issuers and costlier funding across the board.

Emerging markets issuers have managed the very complex environment in many ways. Many issuers took advantage of the accommodative conditions during the pandemic to refinance their debt and extend maturities, offsetting the immediate need to refinance debt at high interest rates.

For those in need of refinancing, domestic markets and banks have provided feasible alternatives, although the latter cannot replace the depth and conditions of international markets, and in some emerging markets, domestic markets are still undeveloped.

Time is running out as maturities come due, and there's likely to be further hardship for those needing financing. Credit pressure is likely to continue, especially for speculative-grade entities.

Emerging market bond managers are looking for the next thing as spreads tighten. Now ratings are on a negative trajectory, there's "a missing middle of 'BB' rated markets." There are special situation opportunities, but they're time consuming to assess.

At the long end, bond market yields are stabilizing, interest rate cuts are expected, and spreads are falling below the level seen at the end of 2022, according to David Hauner, head of global emerging markets fixed income strategy at Bank of America.

"Recent emerging market debt inflows are historically modest, and there is caution around currency. Domestic bond issuance is propping up sluggish totals, a different picture to in the U.S., which has returned to year-on-year growth," Hauner said.

In general, lower inflation in Asia makes it a "nice place to take some duration risk," and the Philippines was highlighted as a large market for bond offerings. Vietnam, while offering a lot of hope, is still considered a frontier market from a corporate perspective.

The period between the last hike and first cut will be the most dangerous; there has been an absence of inflation over the past two cycles, but this one is more 1980s-like. The longer the pause, the more debt that will reach maturity.