An uneven road to recovery in H2

The optimism around a post-pandemic recovery seen earlier in the year has dimmed somewhat, as the Delta variant of COVID-19 surges across the globe. Clouds of uncertainty have gathered, but plenty of positives remain.

Asia’s patchwork

When it comes to recovery, Asia is a microcosm of the wider world: a patchwork of radically different stories about COVID-19. At one end of the spectrum, India is slowly unlocking from a devastating second wave of infections driven by the Delta variant, with a caseload still in the tens of millions and a vaccine rollout that, while vast in scope, is struggling to make rapid inroads into the country’s even-vaster population.1

At the other end of the spectrum, the government of Singapore is making preparations to live with COVID-19 as an endemic respiratory infection.2 Around 37% of adult Singaporeans have been fully vaccinated, a proportion the government hopes to double by early October.3

Vaccination rates are one of two key factors in Asia’s recovery, the other being exposure to trade. Global trade is now flourishing. Trade-geared economies such as South Korea, Vietnam and Taiwan did well in 2020 and are continuing this year. This group includes China, where GDP has returned to pre-pandemic trend levels, amid strong export sector growth and robust manufacturing. Domestic demand is starting to catch up as the economy rebalances.

Less trade-oriented countries are taking longer to recover, seeing some downward revisions to growth expectations this year: India, Indonesia and Japan are unlikely to return to pre-pandemic levels until Q3. A third group lags further still, with major south-east Asian economies such as Thailand, Malaysia and the Philippines conceivably not regaining their lost ground until 2023.

That even a resilient and dynamic upper-middle-income country such as Thailand finds itself in this situation is testament to the hugely negative impact the pandemic has had on flows into its tourism sector, as well as the extent of emergency fiscal expansion, which has rocketed Thailand’s previously low levels of sovereign indebtedness past 50% of GDP.

At the frontier

While Thailand will most likely be fine, this is not necessarily the case for emerging and frontier markets elsewhere. Sovereign credit ratings have not reflected the general deterioration in the quality of sovereign debt, because so many governments have taken on debt in response to the pandemic.

This collective action stabilises the relative picture and prevents any one country being singled out for downgrades, but it doesn’t do much to reassure bond markets. A reluctance among investors around the world to extend duration indicates a nervousness in relation to sovereign and local currency debt. The recourse of many countries to multilateral lending may alleviate that anxiety, depending on the extent of the fiscal relief provided by the issuance of the IMF’s Special Drawing Rights and the willingness of national governments to front-load economic reforms in a way that reassures markets they are taking the debt burden seriously.

Sub-Saharan Africa offers some examples of how policy is influencing investor sentiment. Many frontier markets have been remarkably stable in the circumstances, partly because they are less liquid and thus less reactive to external volatility, partly because their high yields remain attractive to investors. Despite very low vaccination rates, countries such as Ghana and Uganda have actually become more investible over the course of the pandemic, because policymakers have avoided imposing restrictions on how those currencies could be traded. Conversely, Nigeria has been a relative laggard due to the regulators’ policy changes regarding to the naira, which have led investors to see the market as less accessible.

Then again, commodity producers such as Nigeria are well positioned to benefit from roaring global trade, given soaring prices of Nigeria’s main export, crude oil. One complicating factor is OPEC, however. The oil cartel is at odds over whether to increase production, with no consensus yet as to the outcome of the dispute. Markets are likewise undecided on which way this is going to go, and this will be a major focus for Q3. 

Fed centre

With oil feeding into an upsurge of inflation in the US and many other countries, there is even more scrutiny than usual of the Federal Reserve and the trajectory of the dollar. At its June FOMC meeting, the Fed changed its forecast, with median expectations now for two rate hikes by the Fed in 2023. This has led to a degree of market bullishness around the dollar, but it is important to note that the Fed is not acting in isolation so dollar strength is not expected to last.

A number of EM central banks – Mexico, Brazil, Russia to name three – have already raised rates, while others are looking to move before the Fed, such as the Bank of Korea. Central banks in the G10 are also talking about policy normalization over the next 18 months. In other words, the minor shift in the Fed’s forecast does not change our view that the dollar is set to depreciate against a broad basket of currencies.

Currencies in Asia, particularly ones linked closely to the commodity cycle and global trade, are likely to do very well, including the Chinese renminbi, the Korean won, the Singapore dollar and the Malaysian ringgit. Their volatility-adjusted performance over H1 has already been extremely good, and we expect them to outperform in H2 against funding currencies such as the dollar, the euro and the yen.

Concerns over a “taper tantrum” as seen in 2013 are easing. The winding down of Fed asset purchases, likely to be announced in September or November and to begin in 2022, will be a shock to no one, unlike the tapering of eight years ago. Indeed, in the US, it is arguable the “tantrum” has already been and gone, reflected by the dramatic rise in long-term US interest rates, steepening of the yield curve and big increase in real interest rates in Q420 and Q1 of this year.

Most importantly, COVID aside, EM economies are much better placed to withstand tapering, because foreign investor positioning in EMs is much less significant than it was in 2013, particularly as a percentage over overall bond market size. This means that even if interest rates in the US rise, there will not be a tidal outflow of capital from EM. The current account balances of a number of key EMs are also much stronger today than they were in 2013, again protecting against balance-of-payments crises.   

None of which is to say the impact of COVID is in the rear-view mirror. One risk is that the indebtedness piled onto weaker economies produces a dead-weight loss to future growth. Another is that if the external sector begins to waver, it is uncertain whether many economies, particularly in Asia, can generate enough domestic demand to bridge the gap. Nevertheless, these risks aside, the resilience of many emerging and frontier markets during the pandemic has been impressive, and bodes well for future, particularly as multilateral efforts to boost vaccination in poorer countries pick up pace.

1 https://www.reuters.com/world/india/indias-death-toll-coronavirus-crosses-400000-2021-07-02/

2 https://www.scmp.com/week-asia/health-environment/article/3138517/singapore-preparing-live-endemic-covid-19-residents

3 https://www.cnbc.com/2021/07/06/singapore-minister-on-covid-19-vaccination-program-opening-of-borders.html

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