Morgan Stanley In 2024, there will be eight surprises in emerging markets around the world

Morgan Stanley strategist James Lord's team said in the latest emerging market strategy report that with global central banks generally on the track to cut interest rates and the U.S. economy to avoid a hard landing, emerging markets are expected to usher in another good year, but the market trend is not all smooth sailing.

Analysts believe that there are currently 8 major surprises that could have a significant impact on emerging markets:

1.Emerging Market Sovereign Credit Yield Falls to 0%: If U.S. inflation heats up again and Treasury yields**, EM sovereign credit spreads could widen to 450 basis points, with a return of 0. 2.Local currency bonds outperform US dollar bonds: Morgan Stanley expects that local currency bonds may outperform US dollar bonds if emerging market currencies** are in good shape, and that better currency markets will need to avoid a hard landing for the US economy, a rebound in European growth, and improved growth in China to boost commodities**.

3.Return of Emerging Market Inflows: If the U.S. economy can achieve a soft landing, emerging market returns are expected to be solid around 10%, and capital inflows may be expected to recover gradually while maintaining low volatility.

4.Egypt's debt restructuring: With Egypt's interest burden rising from 14% to 24% on five-year Egyptian bonds over the past two years due to rising inflation, Morgan Stanley has speculated that Egypt may undertake debt restructuring in the near term.

5.Panama Copper Crisis: The closure of Panama's largest copper mine could affect the country's sovereign credit rating, and elections in May next year could lead to the reversal of the decision to close the mine, boosting the economy and avoiding a potentially costly arbitral award.

6.100% return on Argentine debt: In an ideal scenario where yields fall to 11%, Argentine bonds could return 100%, but this will require effective implementation of Milley's economic policies.

7.Saudi Arabia lifts all production cuts: This year's production cuts have already affected Saudi Arabia's ability to spend on Vision 2030 reforms, and it is under pressure to increase production.

8.The Colombian peso once again outperforms EM currencies: The Colombian peso is the best performing EM currency in 2023, and Morgan Stanley noted that the Colombian peso is likely to remain in that position next year, but there are already risks in the CFP, and Damo has been hesitant to short the currency.

The first worst-case scenario is that US inflation rises again, forcing the Fed to step in and continue raising interest rates, with the yield on the benchmark 10-year Treasury note returning to 5%.

As shown in the chart below, this would result in EM sovereign credit spreads potentially widening to 450 basis points with a return of 0.

On the other hand, the U.S. economy falls into recession and interest rates fall sharply.

Although the market has long expected a recession, especially given the extent of policy tightening. But in recent months, markets seem to have forgotten about the risk of a recession and turned to pricing in a soft landing.

But Morgan Stanley believes that there are some leading indicators that are deteriorating.

If the U.S. falls into recession, it will have spillover effects on the rest of the world, dragging down commodities** and global economic growth.

Morgan Stanley expects Angola, Nigeria, Mexico, South Africa and Ecuador to be more severely affected by debt returns.

However, the bank also mentioned that a U.S. recession will trigger a rapid pullback in interest rates, which will benefit the performance of emerging market investment grade bonds, and that returns on emerging market investment grade bonds are expected to remain positive, assuming only a mild recession in the U.S. economy.

The second surprise Morgan Stanley called the local currency-denominated Emerging Market Treasury Index (GBI-EM) is likely to outperform the dollar-denominated Emerging Market Treasury Index (EMBI).

Generally speaking, investors who focus on both local currency arbitrage and foreign exchange earnings will focus on the GBI-EM index, while dollar arbitrageurs will mainly focus on the EMBI index.

The analyst emphasized:

GBI-EM will only outperform EMBI if it is backed by Treasury yields**. This is because the sell-off of US bonds could lead to a widening of interest rate spreads and even a default on the bonds of some emerging market countries, which is not necessarily the case with emerging market local currency bonds.

For emerging market FX to perform well, three conditions are required:

1) U.S. economic growth slowed, but it didn't collapse;

2) The European economy is picking up, and the euro remains stable or strengthened;

3) China's economy continues to improve, increasing commodity imports.

The analyst writes:

So far, we believe that the first condition is becoming a reality, and the US economy is entering a soft landing.

European growth appears to be more challenging at the moment, but once the ECB is able to slow down, the economic outlook could improve sometime in '24.

Overall, we think the bar for GBI-EM to outperform EMBI is quite high, but it would be a surprise if that were to happen in 2024.

Analysts point out that the previous years of large capital inflows in emerging markets were 2005-06, 2009-10, 2012, 2016-17 and 2019.

With the exception of the Fed's rate cut in 2019, the common performance of emerging markets in these years was low interest rate differentials, low volatility, and consistently high returns.

Analysts noted that while starting spreads are likely to be above 400 basis points next year, which is still relatively high, if the U.S. economy can achieve a soft landing, emerging market returns are expected to be solid around 10%, and capital inflows may be expected to recover gradually while maintaining low volatility.

The analyst also highlighted the following:

The recovery in credit returns in emerging markets tends to attract flows, but lags behind. If the recent surge in earnings is followed by a longer period of stable earnings in 2024, similar to the situation in 2017 and 2019, there is a possibility that inflows will continue to follow.

Restructuring local debt would complicate matters given financial stability.

The situation in Egypt is more complicated, as most of the bonds issued in the past two years have gone more to treasury bills, which are often excluded from the debt spectrum because they can have a profound impact on interbank liquidity, which can affect the banking sector and overall financial stability.

It is assumed that all bonds have a 20% write-down, a 20% coupon adjustment and a 7-year rollover. In this case, assuming an exit yield of 12%, the Egyptian national index falls back to 47. Clearly, the current lower level of long-term bonds** has already priced in some credit events**.

A more drastic restructuring (40% write-down, 30% interest cut, 10-year rollover) would bring the Egyptian national index to 30, while a minor restructuring (20% write-down, no interest rate cut, 5-year rollover) would keep the index at 56.

The growing number of non-OPEC** and the mediocre compliance of OPEC members in voluntary cuts could lead Saudi Arabia to focus on market share again. This creates a difficult operating environment for exporters with low excess capacity and high profit and loss.

Morgan Stanley believes that the permanent closure of the mine could have a negative impact on Panama's sovereign rating, but under the new leadership, Cobre Panama still has a chance to resume production.

First, Morgan Stanley noted that the mine accounts for 60% of Panama's total copper exports and contributes a very high (3%-4%) to the Panamanian economy. Once permanently closed, the Panamanian economy could fall into negative growth.

And 3%-4% only takes into account the negative impact on GDP and does not take into account the impact of foreign investment that may be lost.

Rating agencies, including Standard & Poor's and Moody's, are keeping a close eye on the Panamanian copper case, which could lead to negative ratings if the mine is indeed shut down completely.

Next year's elections in May could lead to the reversal of the decision to close the mine, helping economic growth and avoiding potentially costly arbitral awards.

Morgan Stanley believes that Argentine bonds could return 100% in an ideal scenario where yields fall to 11%, but this will require effective implementation of Milley's economic policies.

After the far-right candidate Milley won, Argentina's bond has reached 25%.

At the moment, Milley is pushing hard to dollarize Argentina. Morgan Stanley pointed out that the current IMF and other institutions have expressed their willingness to participate in Argentina's fiscal adjustment, which is a good start.

Milley still needs to implement:

1) Support from the Argentine community;

2) The market remains confident and the outflow of capital is under control

3) Maintain the growth of foreign exchange reserves.

Given the severity of Argentina's macroeconomic imbalances, it all depends on near-perfect policy execution, the analyst noted

While Milley is off to a good start, we believe the execution phase will be trickier. As such, we remain neutral on Argentine bonds.

However, with the impact of the production cuts on Saudi Arabia's own fiscal and economic growth, and the division of opinions within OPEC, Morgan Stanley believes that Saudi Arabia may cancel the production cuts, stop trying to push oil prices higher, and turn to competing for market share.

In the third quarter, Saudi Arabia's oil and gas revenues were the lowest since 2021, resulting in a budget deficit of about $10 billion, affecting Crown Prince Salman's Vision 2030 reform ambitions.

The analyst writes:

Oil exporters with high break-even points are the most affected: the surge leads to oil prices, which could hurt higher-cost global oil producers such as Bahrain, Angola, Nigeria and Ecuador.

The Colombian peso is the best performing emerging market currency in 2023, and Morgan Stanley noted that the Colombian peso is likely to remain that position next year, but the Colombian peso is already at risk.

As of December 8, the Colombian peso was about 21 year-on-year5%, almost double the Mexican dollar, the second-best performing emerging market currency this year (+12.).4%)。

Morgan Stanley believes that the strength of the Colombian peso is due to the sharp improvement in interest rate differentials, the Colombian peso is very cheap, and the central bank of Colombia has raised the policy rate to the highest level in South America (13.).25%)。

Analysts said:

The situation in the Colombian peso looks more challenging in 2024, so we expect a more bad performance next year.

While we have been bearish on the Colombian peso and have been emphasizing that its valuation looks quite expensive, we have been hesitant to short the Colombian peso due to the high spreads and the degree of correlation with local bond inflows.