Time to consider emerging market debt

In addition to commodity prices, Latin American currencies and other commodity exporters such as Russia and South Africa would also suffer, while importers such as Turkey would benefit from the unexpected development. What all these countries have in common, however, is that a growth shock in China would not have much of an impact on the financing prospects given the low default risk in emerging countries. The market would surely vote with its feet as investors digest the negative data, and high yield sovereigns such as Venezuela and Argentina would see their borrowing costs increase more than their regional peers, but their ability service debt would not be impaired. It would take more than a temporary decline in Chinese growth indicators to upset the apple cart, as authorities would likely respond to a sharp slowdown with easier monetary policy and fiscal stimulus. Albeit, the latter would not be on the same scale of the unprecedented bank lending following the 2008 global financial crisis. China will not save the world, but the stimulus would likely restore growth back to levels that would be supportive for risk assets.

Aside from a hard landing in China, there are a few other risks that could have an impact on emerging markets, although these have more to do with short-term valuations rather than triggering credit concerns, which should remain sound unless we see significant fiscal loosening, central banks sacrificing inflation for growth and increased political risk. The most pressing risk at the moment is a blow-up in the eurozone, prompted by a disorderly Greek default that results in rising yields across the other peripheral countries. This, in turn, would result in a sharp fall of the euro as investors seek the safety of the U.S. dollar, which would be negative for emerging market currencies. Emerging market hard currency bonds—in particular, high-grade Latin America sovereigns that behave like U.S. Treasury proxies—would benefit amid the risk aversion. A reversal of inflows into emerging market local currency funds on the back of rising risk aversion would be another negative for the asset class. There was little sign of capitulation amid the big outflows in October 2011, as this was largely retail rather than institutional money moving to the sidelines. Now, if the latter investor base were to change its view on emerging markets, it’s questionable whether there would be enough liquidity in some of these local markets to enable an orderly exit. Perhaps the markets are getting a bit sanguine about the recent U.S. macro data, as a renewed slowdown later this year could also impact risk assets, although we see this as a much lower risk for the asset class than developments in Europe.