Emerging-Market Debt Outlook 2023: A shifting balance of risks

By Godwin Anyebe

Financial markets offered few opportunities for refuge in 2022, and emerging-market bonds were no exception. Analysts expect the past year’s difficult conditions to gradually unwind in 2023, but risks remain, and investors will need to be selective.

Global growth is expected to face stiff headwinds this year, which could pressure commodity prices. Higher commodity prices are generally positive for emerging markets, especially when the US dollar is weak. The cycle over the past two years has been somewhat unorthodox, with commodity prices rising sharply alongside a strong US dollar. This created tension between high- and low-quality credits, with lower-quality credits suffering the most.

While commodity weakness would help contain global goods inflation and reduce the risk of soaring funding costs, it could also prove challenging for commodity-dependent countries with large external financing requirements—particularly those with negative basic balances (Display) and limited bond-market access.

If deteriorating economic conditions lead to a deep or prolonged cyclical trough, the global monetary policy cycle could pivot, although baseline expectation is for a prolonged policy pause.

Emerging-market investors are already seeing light at the end of the policy-tightening tunnel. Analysts believe that the tightening cycle is more than 80% complete, with growing evidence that core inflation is decelerating. This means one of the major macro-level headwinds for emerging markets—the tightening of global financial conditions—is abating.

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Inflation has been anything but transitory, however, and despite evidence of disinflation, experts don’t expect inflation to fall back to pre-pandemic levels in 2023. This could limit central bank maneuverability and might ultimately force central banks to accept higher inflation as a new normal.

One reason for lackluster emerging-market performance in 2022 was China’s economic underperformance, due in part to lockdowns aimed at staving off the spread of COVID-19 infections. While China’s decision to wind down its zero-COVID policy is encouraging, it isn’t likely to supercharge the growth outlook for emerging markets.

Still, this long-awaited economic reopening, coupled with China’s low commodity inventories, could help stabilize commodity prices and emerging markets as a whole. At the very least, it will remove one of the major obstacles to emerging-market asset prices.

While Analysts could see an end to rate hikes in early 2023, policymakers aren’t likely to cut rates as quickly as they’ve been able to in previous cycles. The policy pivot might come too late, or the macro downdraft might be too forceful, to avoid distress in the frontier space of emerging markets, where credit stress is high (Display).