2023: A more favourable year for bond returns
Economic Growth Outlook: Although key Developed Markets (DM) are expected to register negative GDP growth this year, economic conditions are expected to hold up better for the EM universe. EM-wide growth will be supported by China’s recent reopening, following several years of pandemic-induced mobility restrictions. Key risks to the EM growth outlook include the likelihood of the China reopening being disrupted by high Covid-19 infections following the holiday season (not our base case), or economic conditions in major DM deteriorating more than expected – with further knock-on effects on developing countries.
Source: Bank of Singapore
Fiscal Outlook: Political pressures will continue to mount on governments to maintain, or prolong, costly social protection measures (e.g. food and energy subsidies, social grants, etc.), many of which were initially aimed at providing citizens with only temporary Covid-19 related relief at the height of the pandemic. Countries such as Egypt were already in advanced stages of phasing out long-standing subsidy programmes, but have now had to retain them further to enhance social safety nets. The same is true in the case of social grant extensions in Brazil and South Africa, or minimum wage subsidies in Colombia. As such, most EM sovereigns have entered 2023 with limited room to manoeuvre on the fiscal front. We also expect sovereign debt burdens to remain elevated, following two years of pandemic-focused fiscal interventions, and for government debt servicing costs to increase (in both local and external debt terms) this year.
Source: International Monetary Fund Global Debt Monitor, 2022; LIDC=Low-Income Developing Countries; DM=Developed Countries
Inflation Outlook: A weaker USD and somewhat lower (but still high) average oil prices should help tame inflationary pressures within the EM universe. However, we see a high likelihood of wage pressures persisting a while longer– particularly within the public sector. Higher energy prices may also continue to cloud the economic outlook in Emerging/Eastern Europe. The advantage for fixed income markets is, if inflation persists – globally and across the EM universe – the market is unlikely to be as surprised by its persistence, as it was by its resurgence in 2022, thereby preventing similar bouts of US Treasury (UST) yield volatility, when the market initially expected inflation to be “transitory”.
Monetary Policy Outlook: Broadly speaking, EM countries will converge towards monetary policy normalisation during 2023, including in Asia, which initially lagged other regions during the current rate tightening cycle. An increasingly more challenged growth outlook within the EM universe, following a round of multiple rate hikes last year, and general market expectations of a marked slowdown in Fed tightening, should also prompt policymakers to temper their recent hawkishness – even if nominal rates may stay elevated for much of the year.
Bond Issuance: We see gross bond issuance being higher this year, compared to last year’s level of USD77b, as market volatility likely subsides, and UST yields tighten – in line with our 6-12 month forecasts for lower UST yields. Year-to-date, we see issuance still being dominated by IG issuers. Even if we see a gradual reopening of primary issuance activity, refinancing risks associated with HY issuers will likely remain elevated (with continued indications of distress within the single B – and lower rated segments, comprised mainly of smaller Frontier Market issuers).
Bond Performance Outlook: Markets have already begun to price in peak US inflation, a weaker USD and the imminence of recession, as we move into 2023. Hence, we envisage a more gradual tightening of yields – perhaps interspaced with brief periods of yield/spread retracement in between, in reaction to adverse news flow – but certainly no return to the July or October 2022 low yield/spread highs. In this regard, several market indicators already show this as being the case thus far. Firstly, USD strength appears to have peaked around October/November (See chart 4); secondly, capital flows into EM also seem to be recovering from their October 2022 lows, when global financing conditions were extremely tight. Still further, US short-term break-even rates – at around 2.3%; – are already implying lower inflation over the next two years. All these indicators are positive for investor sentiment towards global and EM bonds.
We are Neutral on EM bonds and hold a constructive view of duration, particularly for IG rated sovereigns and select BB-rated HY issuers currently trading at high yields, to be able to provide a buffer against further UST yield increases. We remain cautious of single B-rated (mainly Frontier Market) issuers that are vulnerable to further external shocks from elevated USD strength/tightened financial conditions and the spillover effects of the Russia-Ukraine war. These negative aspects could continue to prevent lower-rated HY issuers from accessing the capital markets – either for new funds or refinancing needs. Expected loosening in financial conditions, as the Fed slows down the pace and extent of its rate hikes, combined with a weaker USD should aid the revival of investor appetite for EM risk assets, including sovereign bonds.Disclaimer applicable to recommendation
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