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This is Winnie Caesar, Global Head of Strategy at Credit Sites. And today I have one of our strategy teammates joining me, Regis Chatelier, our head of EM Sovereign Strategy, who has really ramped up an amazing amount of coverage in the EM Sovereign space over the past year and a half, almost two years at this point that you've been with us. That's about, it's going to be two years in March. I think it was pretty good so far.
I think it's been very good so far. And time flies when you are ramping up strategy coverage of a pretty big and diverse market. We're going to be talking about the EM Sovereign Market, what happened in 2024, the expectations for 2025. And Regis, let's just start there.
Can you give us a quick recap of EM in 2024? Because I think it surprised a lot of people with the magnitude of strength. Yeah, indeed. I have to say, this was quite incredible year for sovereign high yields, specifically.
If you look at sovereign credits, the index overall, it returned 5.4%, which is not that amazing. But at the same time, this performance was quite an even performance for EMIGs, was quite disappointing. They declined by 0.6% because of uncertainties regarding US inflation and Fed moves and US treasury market. And because of that, EMIG spreads also widened by 15 basis points.
So clearly, this is not where the value came from. But by contrast, sovereign high yields had an amazing year. They returned 15.4% to be precise. And that followed 2023 with a bit more than 15%.
So that's nearly 30% in two years. And in fact, if you look at this year or 2024, here my yield achieved one of the best performances within fixed income. They returned nearly twice as much as US corporate high yields, as you know, it returned something like 8%. A bit more than 8%.
So that's nearly twice as much. So very, very strong performance and two years in a row. But that being said, it's also important to note that the very strong performance in EMIG yield is a bit deceptive because it's been driven by six countries, essentially, namely Argentina, Ecuador, Ukraine, Pakistan, Egypt, and El Salvador. Two give some numbers.
Argentina rallied by 100%. So that's twice as much as the variations than a year ago. So massive rally. Ecuador close to 70%.
Ukraine close to 60%. Pakistan 40, Egypt 33, and Salvador 30. So overall, we had six countries accounting for roughly 70% of the sovereign high yield index return. But if you look more specifically, the median return last year in EM high yield was around 6%.
So much more, much lower. But it's still very strong performance. On the other side, we had IG countries struggling a bit, Mexico in particular. We spread white and white bits, Romania, Panama, with also kind of specific problems.
But as a result of all this, we had the spread differential between EM high yield and EMIG that narrowed by more than 200 basis points. And in fact, we are now at the tightest level since 2018. And I would say the tightest levels in the past decade. So the tight spread, tight levels that we're seeing in the US corporate market, Euro corporate market, it's also rampant in the EM sovereign market as well.
Yeah, that's what I was about to say. Now, I mean, what was this performance in EM high yield surprising? I would say, yes or no. I would say market conditions were particularly ferible, the Fed cutting rates, low volatility, commodity prices remaining relatively high on average, which is good for EM because EM exports a lot of commodities.
And that led to also a decent amount of debt assurance and improved liquidity in EM also. And that's probably an important argument. A market fundamentals have improved in 2024. You had something like 36 emerging markets and developing countries that were upgraded.
So that's quite a lot by historical standards that twice as much as the number of downgrades. We had big countries, big countries, big countries, big countries, including Brazil, Argentina, Turkey, Saudi Arabia, Egypt. We had also inflationary pressure, more contained, for example, in Turkey, which was a nice surprise that finally the central bank time and monetary conditions, GDP growth improved. The IMF provided support for the most vulnerable countries, including Argentina, Pakistan, Egypt.
GCC countries provided also a big financial support to some countries, namely Turkey, Egypt, Morocco. And we had also several defaults that were finally resolved by debt restructuring, that was the case, especially in Africa, like in Ghana, but also finally Sri Lanka that managed to restructure Ukraine because of the conditions. They had not to do restructuring, but they pushed back a big payment. So all these countries could start with a fresh new start.
So I would say all the stars were aligned in 2024, and that's good. Now, if you ask me, was there a big surprise? I would say probably Argentina. Again, 100% return.
This is quite crazy. Why is that? I mean, we can praise the fiscal consolidation that's been quite massive. The falling inflation met also.
We need to remember the seamless support of the IMF. I mean, without the IMF, basically, Argentina would have defaulted. We need to keep that in mind. Now, very few investors would believe, or were believing that austerity measures would be easily accepted by the population.
In fact, if you look at the economic situation, the fiscal consolidation led to a sharp recession. In Argentina, given the history of Argentina, you could have thought that it would have triggered massive protest, and President Millet would have to backtrack on his plans. So this was a positive surprise. Clearly, all stars were aligned in 2024.
So I would say this was definitely a good year, and especially for EMHayil. Yeah, absolutely. I think that it surprised a lot of clients that I was speaking to, that the markets performed as strongly as they did, especially because it was strength driven from a mix of fundamental improvement and incremental technical momentum with that kind of supply and demand dynamic being pretty well balanced. And then those outlier performances from countries like Argentina and Ecuador, etc.
So as we head into 2025, is this going to continue? Are we just primed for EM outperformance in perpetuity? How are you thinking about market recommendations within EMS to start the year? First of all, I mean, we need to keep in mind that fundamentals have improved, that's the good starting point.
I would say EM growth forecast is expected around 4% into 2025. That would be around 4.2 if we include China, but that's still an improvement from 3.8% into 2024. There's some concern about China. We know that or we know what's likely that economic situation isn't likely to improve in their very short term.
The economy is accelerating. But if you look at the rest of Asia, its economic performance is still very robust in Southeast Asia. If you look at India, Philippines and Indonesia, Philippines and many years are very big markets for sovereign credit. Latin America, I would expect central banks to ease monetary policy to stimulate growth.
Real rates are still pretty high. Mexico will likely to implement pretty sizable rate cuts. Eastern Europe, the economic is quite uneven, but some countries are doing quite well. Poland is performing quite strongly.
Middle East, I think in the end, they're likely to increase oil production and especially to develop non-oil activities. And finally, Africa, I mean, typically, growth in Africa is quite strong. And that's going to be the case, probably with the exception of South Africa. But even South Africa has been improving lately.
So overall, I expect the growth gap between the markets and advanced economies is likely to widen further. So that puts EM in a pretty decent starting point. Inflation pressures are contained. FX reserves are on the rise, which is important as far as the buffer to sort external shock is concerned.
We have debt levels as stabilized across EM. And in fact, the situation looks comparatively better than in developed markets. So you probably know that. So that's the starting point.
But if you look at valuations, I mean, probably went a bit too far. I mean, stars were aligned in the last year, but I would say in 2025, we may go down to Earth. And I would expect some spreads to do well with the MI yield, IG spread to go back to the 400 basis points area versus 200 basis points at present. So I would say this is going to be a pretty significant spread winding.
Now, what is going to drive the reprising? I think there's quite a lot of risk. And I would mention three of them that would put pressure on spreads. First, I mean, as I said, valuations are very tight and there's not much buffer against downside risk.
Overall, if you look at valuations, current spreads are consistent with one notch rating upgrade for the entire EM spectrum, which is obviously quite unrealistic. I'm giving the fact that a lot of countries were already upgraded this year or last year. And so therefore, I think the risk is tilted to the downside from this respect. The second risk is fiscal deficits are still quite significant across EM and developed markets, by the way.
On average, the EM, budget deficits are around 4% of GDP. So it's not that there's much room for maneuver in this respect. And the third risk, and probably the most important one, is political and geopolitical risk are clearly on the rise. I mean, just turn on your TV or just an internet.
It doesn't take long to see that. First, I mean, I would say, don't want to plan to increase trade tariffs likely to impact emerging markets. I mean, first of all, it could be inflationary for the US itself. It could force the Fed to maintain rates, you know, relatively high, depending on the scenario.
But that would in turn increase refinancing costs for EM insurers. But the most obvious impact would be that high tariffs would impact EM exports. And that would in turn also impact public finances or EM, because EM typically quite dependent on export revenues. So it would be a dual one on an EM.
China, most likely to be the most affected by US trade tariffs. We all know that, but also Mexico. It's also the target. But we would see even some additional risk affecting Latin.
I mean, if you look at Panama, for example, with Trump intentions to reclaim Panama Canal. So that's the kind of risk that EM is facing. But independently from that, you can, or I would say, CE countries, you would think that it could be a bit more protected against trade tariffs. But in fact, most CE countries depend on exports and especially towards Germany.
But Germany will be very likely a big target for US tariffs. And economic situation is not that great. So in fact, you could have a knock on effect across EM or all these tariffs. So that is clearly not priced in, in my view.
Another aspect of political risk is in Eastern Europe. We have populist parties that on the rise in CE, but also in developed markets. And that raises the concern about the ability to implement fiscal consolidation measures, keeping in mind that fiscal deficits are pretty wide in the region. We have also the political situation in Germany and France, also quite complex.
We could have, again, a snap election in France probably in the summer. So it's a lot of uncertainty. Obviously, situations in the Middle East, still very tense, uncertainties about Russia and Ukraine complex. So the list is quite long.
So it makes the environment quite complicated. And I think all these recently are not priced in, clearly not at these kind of spread levels. Yeah, it is astounding to me just how resilient markets were post the US election, given the trade policies that have been floated by Trump and his administration. Do you think that people just don't believe that tariffs are going to be implemented to the magnitude that Trump had been talking about?
And so everyone's just kind of waiting to see it because I would expect it for the EM market, it would be quite detrimental if we see these kind of massive global tariffs. Yes, it would be. I mean, at the same time, there is probably some, I mean, with trade tariffs, part of the trade would be probably redirected with an EM. Like, for example, you increase tariffs on China, but probably part of the trade would be redirected that was initially intended for US and possibly Europe, but it would be probably the amount elsewhere.
Now, effectively, it's still a big impact. And I think my concern was that the market is quite complacent. We are in a sort of, I mean, I'm going to say the word, which is a bubble, right, which I don't use very often. But the fact that these kind of obruptomistic kind of feeling about the state of this world, the fact that systematically the trade tariffs are going to be downplayed eventually and we will have some sort of, I think the US administration's come with much stronger kind of purpose than the first time.
I think I'm not sure that Donald Trump necessarily had very clear what he wanted to do and what he would be able to do. But I think his administration has a much clearer and stronger agenda, right? I mean, look at the statements about Greenland and so forth. I mean, you can argue this is going to be realistic or not.
But I think the tone is quite bold and I think he wants to achieve something, right? He wants to leave something for history and I think maybe he is going to pay the price for that. So I'm not totally optimistic about the fact that the market was a bit complacent and we need to reassess that somehow. Yeah, I absolutely agree.
And we've been more cautious on the corporate credit side of things because of that feeling of market complacency. And I would say it's quite surprising to me as I'm talking to clients to start the year, the question is not so much what could go wrong, but how much trade or can spreads go? It's going to continue out to outperform. And that always gives me a little bit of caution or pause when everybody crowds into one side of the trade.
Now, in order for us to be wrong on the corporate credit side of things, spreads need to continue to grind tighter. We need to continue to see fundamental improvement and really strong technicals. I suspect that's the same for EM as well as you're expecting to see some spread widening there. So what would be the bull case scenario for EM sovereigns right now?
Would it just be 2024 part two? The bull case, well, I think the most important thing is probably that trade tariffs are eventually downplayed. Trump does not implement these tariffs so aggressively. That would be the most bullish case.
That's one second. Your political risk are eventually not materializing. I have some concerns. If you look at the situation in Eastern Europe, for example, how political running coalitions or presidents are relatively weak position to consolidate the budget.
But no, things can improve. Obviously, if inflation in the US continues, that would be a bull case for EM overall as it would be for fixed income. But again, it's difficult to see. If you look at the risk, if you make a list on one side, a typical bullish case, you have a couple of bullet points and the risk of the risk of the risk is actually quite long.
So the risk reward is not that favorable overall. Again, I think fundamentals are better, but there are external factors that can put pressure on spreads going forward. Yeah, absolutely. It'll be a really interesting year to see how everything unfolds.
And part of me thinks that perhaps it will take a bit longer for the spread widening to materialize because it's going to take a bit of time to understand what the policies are going to look like coming from the Trump administration. And then it takes extra time for those policies to actually work through economic fundamentals. But the reality is the market sells first or buys firsts and then asks questions later. So I think some spread volatility is a pretty easy base case for 2025.
Now with that in mind, we are in the business of providing recommendations and investment ideas to our clients. So as you're looking through your coverage universe of EM Sovereigns, are there any outliers that are still compelling opportunities or places that you would say, absolutely not, please walk away from this and there will be a better buying opportunity later? Well, it's difficult to have like best picks, you know, and quite defensive on positioning. So in this environment, you tend to be quite conservative.
I would say still on the fundamental side, there's probably some good news with some countries likely to receive rating upgrades this year. I would probably mention the case of Philippines, Oman, Dominican Republic, Serbia, potentially Indonesia, Indonesia doing quite well. On the other side, I have some concern about Romanian Panama being at risk of losing their IG status. But as far as purely kind of market performance for the solving debts, I would say Poland, I have it on a perform.
Gross has lost the big momentum the past few months in Poland. But I would say that the medium term outlook remains quite positive. In fact, this has a lot to do with the increasing of EU funds that were locked, you know, for quite some time because of the previous government and the tense relationship with the EU. And these EU funds are gradually released and that's going to likely boost long-term investments and is going to also help to fund the deficit.
So I would say Poland is in a pretty decent shape going forwards and it's also pretty sort of a low beta. So I'm quite positive about Poland relative to the rest of the market. In the high yield spectrum, I mean, difficult to be sort of bullish because as I mentioned before, I think high yield variations are very tight. But I would mention Brazil.
Brazil is a bit kind of a, it could appear as a strange call, but typically in the serving credit space, Brazil tend to be quite defensive on the external debt side simply because Brazil has a lot of X reserves and that typically protects Brazil. In fact, when you have a sell-off, most of the risk is materialized in the in the effects, you know, in Brazil, real and the local bonds typically more vulnerable. But you know, the external debt part is actually quite small for Brazil. So it tends to be more, more, more defensive.
The concern and the underperforming side, that's probably where the biggest calls are. I'm concerned about Mexico in the IT space. My concern is obviously the impact on tariffs from the next administration in the US, but also the public deficit that would be in the increasing pressure from because of them X, you know, these all companies that need to be bailed out in many ways. So that's going to continue to put pressure on the budget.
So the combination of high tariffs and also PAMX funding needs that are huge. That doesn't make a very good mix in my view. And not everything is priced in. Romania, as I have it under the format, just recently put out a note on Romania political situation is quite difficult to be honest.
They canceled the presidential election recently because of suspicion of fraud and manipulation of the media and social media. But if you look at the fiscal situation, independent political situation, fiscal situation is difficult. And the external balance is also quite under pressure. And that's quite structural, I would say.
And I don't think the political situation, given as it is with the rise of the far right, I think it's going to complicate the next government. The consolidation measures are going to be very slow. And I think it's going to remain losing its IG status. I would say Nigeria, I have it also underperformed, even though Nigeria has done a bit better recently.
But it's not that things have been so bad in Nigeria, but valuations are very tight simply. And that's true very much. So for the very high yield spectrum. So if we have downward pressure on the market, I think a country like Nigeria would be typically more under pressure because of the high beta relative to the index.
So that's basically where I see the positioning being more effective for next year, quite defensive, I have to say. But again, risk reward, looking at valuations, I mean, that's what I would recommend at the stage. Excellent, Regis. A really comprehensive overview of the diverse world of EM sovereigns, a lot going on there.
But it seems like it all comes back to US trade policy and what the outlook is. So we will be keeping our finger on the pulse of that in the near term. Regis, thank you so much for joining me. Thank you everyone for listening.
If anyone has follow up questions for Regis, you can always reach out to him through the credit sites, ask an analyst function. He is always happy to chat EM sovereigns. He's also been helping our energy analyst, Chas Johnston, cover Pemex, which is clearly a huge capital stack in the EM corporate world. Regis, thanks so much for joining.
And best of luck in your 2025 EM sovereign coverage. Thank you.