Against the dramatic backdrop of the war in Ukraine and the gloomy prospect of stagflation, credit markets keep delivering growth and prosperity.
Inflation, or stagflation? In the wake of Russia’s invasion of Ukraine and China’s ongoing pursuit of its zero-COVID strategy, economists and policymakers are growing increasingly gloomy about the future. Many predict that rapidly rising prices and the looming possibility of negative growth will lead us into a period of stagflation by 2023. But when it comes to credit markets, it is possible to look beyond the current turmoil to a possibly brighter second half of 2022.
A difficult start
Russia’s invasion of Ukraine exacerbated a number of weaknesses in the global economy. The war has further disrupted supply chains already under stress due to ongoing and stringent COVID-19-related controls in some major exporters, notably China, coinciding with a swelling of demand in others as they unlocked from restrictions. Energy producers and traders in particular struggled to meet a sudden resurgence in demand from the nadirs seen in 2020 and 2021, and sanctions on Russia placed even greater pressure on fuel supplies.
As a result, the global economy has snapped from a deflationary position to an inflationary one. Prices that were already on the up have been sent soaring by the food and commodities supply shocks stemming from the war in Europe. Many countries are attempting to sever Russia, physically the world’s largest country,1 from their supply chains, and Ukraine’s global breadbasket has been crippled by the crisis.2 Meanwhile, India has banned the export of wheat after a heatwave damaged harvests and pushed up domestic prices3 and, unsettled by the ongoing conflict, a number of other countries have also imposed export restrictions on various commodities, from soybean to sugar.4
Even in the most resilient countries, the crises have served to slow the pace of the recovery from COVID-19. Countries like Thailand, which hitherto had very low levels of inflation, have seen it surge above target.5 However, central banks are limited in what they can do to respond – simply hiking their benchmark rates does not magically create more oil or wheat on the market. In both emerging markets (EMs) and developed markets (DMs), inequality is growing and a cost-of-living crisis is biting into real incomes.
The multiplying shocks are pushing some economies into recession and many markets into food and energy insecurity, with political instability following in its wake. Thus far the starkest example has been Sri Lanka, which has experienced violent unrest, political upheaval and a sovereign default – Asia’s first for decades.6 Yet this level of distress is not the norm in EMs, and understanding the differences between the state of their economies is important in understanding credit markets.
Not all bad news
There are reasons to believe that major developed-market economies are more resilient than they were before the last major economic crisis in 2008. In the US, for example, even if rate hikes do inject some more slack into labour markets, the unemployment rate is currently a mere 3.6%7 – extremely low by historical standards. It would still be low if it rose to 4.6%. Moreover, US banks’ capital and liquidity positions are robust.8
“While we are facing watershed moments in terms of inflation, a war and so on, the ability of the system to manage that and provide credit has never been stronger,” said Henrik Raber, Standard Chartered’s Global Head of Credit Markets, speaking at the Global Credit Conference 2022 in London on 18 May. “Overall, I think markets have proven to be very resilient.”
When it comes to emerging-market credit, real yields are currently quite low across the board, primarily a result of inflation, and the current strength of the US dollar poses a further headwind to EM borrowers. This strength reflects both economic recovery in the US and an international flight to safety, but these effects may dissipate in the second half of this year as the US growth story starts to fade somewhat and more economies around the world recover from the pandemic.
Many central banks, in both emerging and developed markets, are on a rate-hiking cycle, offering risk premia and term premia to investors in their credit. Some EMs, notably in Latin America and Eastern Europe, find themselves ahead of the game in terms of this cycle, which could benefit the local currency trade.
For energy producers in emerging markets, higher prices present a windfall, as many seek to end their dependence on Russian oil and gas. This is likewise true for countries such as South Africa, which produces metals like palladium, a major Russian export. Even for high-yield sovereign bonds, the risks are already reflected in the price to some extent, which again means examining them on a case-by-case basis rather than assuming those risks are simply intensifying.
For investors, the watchword is diversification. Russia was a very big part of various indexes, with its place now being taken in many cases by Gulf states, which could cause concentration risks for portfolios. Likewise, credit investors need to monitor their exposure to China, a country which anchors many Asia-Pacific economies and where the COVID-19 strategy has negative implications for China’s short-term growth and thus that of the region.
Three credit trends to watch out for
Assuming that the world economy begins to stabilise in the second half of this year, the dollar’s strength fades and supply chains begin to work out how to function in the new reality, Raber suggested that credit markets may move beyond their immediate crisis-management mode. He pointed to three important trends that will instead grow in prominence.
- The first is debt relief and debt transparency. The situation in Sri Lanka has illustrated the chasm of inequality that has grown not only between different classes of society, but also between countries in the emerging and developed world. Initiatives such as the World Bank’s Debt Service Suspension Initiative9 are likely to become more prominent as the world moves into repair-mode.
- The second trend will be ever growing importance of environmental, social and governance (ESG) factors and their relationship to lending. While the war in Ukraine may alter the path of ESG somewhat, it also presents a strong argument for the need to accelerate the shift away from hydrocarbons. There is no doubt that renewable energy is here to stay, and so is ethical investing, with Raber seeing greater emphasis from investors on social and governance factors in the years ahead. “Gender finance, for example, will become a much stronger theme in coming years,” he said.
- Finally, infrastructure will be an important theme in both developed and emerging markets and is going to be full of opportunities. The overlapping global crises have shifted discussions away from globalisation and towards localisation and onshored supply chains, but these will require new infrastructure investment across all markets. The infrastructure sector offers excellent investment opportunities for both equity and debt participation in various tranches, formats and sectors.
What has been striking about this year, Raber noted, is the resilience of credit markets. Their relative strength in the face of several crises is the one luminous silver lining that can be discerned among the dramatic events of the first half of 2022. It suggests that while there are pockets of market instability and dysfunction, overall the market plumbing of global finance has never been better prepared to handle adverse conditions, and to keep delivering the growth and prosperity that EMs, in particular, are counting on for a brighter future.
This article is based on themes discussed during a panel at Standard Chartered’s recent Global Credit Conference: Riding the wave. View the recording.