EMERGING MARKET DEBT RALLIES ON A WAVE OF LIQUIDITY August 2020 On the back of a second-quarter rally across emerging market debt (EMD), sovereign bond

vulnerabilities still vary signifi cantly by region and country. Lower oil prices offer a boost to oil importers like the Dominican Republic, but if prices fall back to the US$20–$30 range it could spark a solvency crisis for some oil exporters. This paper showcases two oil-exporting sovereigns, Angola and Iraq, which still offer upside opportunities despite headline risks. As Africa’s second-largest oil exporter, we believe Angola’s prospects rest heavily with China, its chief export partner and lender. For Iraq, its big hurdle isn’t a large debt burden; rather, it is restructuring the state’s public payrolls and pension obliga-tions amidst rising poverty.

Emerging markets ended the fi rst half of 2020 on a note of confi dence, even as the COVID-19 pandemic accelerated in parts of Latin America and elsewhere. Initially kicked off by the US Federal Reserve’s (Fed) “shock and awe” policies, a tidal wave of central bank stimulus and quantitative easing (QE) spilled over into the developing world, putting a fl oor under risk assets as shown in Exhibit 1 (on the next page). In a handful of emerging countries like Indonesia and South Africa, central banks are also buying their own government bonds, though with noticeably less fi re power than the Fed or the European Central Bank.

All combined, the relief rally in EMD is welcome news; that said, returns remain bifurcated between investment-grade sovereigns, which are positive through June, and high-yield bonds, which remain modestly down (see Exhibit 1). Given uncertainties over COVID-19’s trajectory, many investors remain cautious toward high yield. Investing with confi dence requires deep bottom-up analysis as each sovereign faces unique hurdles.

CONTAINING COVID-19 TO REOPEN ECONOMIESIf we have learned one thing from COVID-19, it is that early lockdowns, combined with masks and social distancing, can dramatically dampen virus transmission and avoid exponential growth in cases. In many parts of emerging Asia and Africa, mask-wearing

Perspective fromFranklin Templeton Fixed Income

2 Emerging market debt rallies on a wave of liquidity

habits and other virus containment measures were already in place from previous SARS and Ebola outbreaks. To reopen and remain safe, countries need to suppress recurring outbreaks with high testing rates and tracing capabilities. In this regard, China has managed COVID-19 better than most and can now point to its economy to prove it: China’s gross domestic product (GDP) grew 3.2% in the second quarter, as shown in Exhibit 2.

China’s rebound has so far been largely industry-driven, with consumer spending weaker than expected. With government infrastructure projects going full steam ahead, China’s oil consumption is back to pre-pandemic levels, as is China’s demand for industrial commodities like iron ore to feed its steel mills. For commodity-exporting economies in China’s orbit, like Zambia and Angola, this is very good news.

OPPORTUNITIES IN DISTRESSED MARKETSIn terms of weathering the COVID-19 recession as an EMD manager, the path forward is all about fundamental analysis on a country-by-country basis. For oil-exporting economies, debt sustainability is often driven by oil prices. Some sovereign economies are tied at the hip to China’s recovery, whereas others will benefit more from a US rebound.

EM SOVEREIGN BONDS REBOUND FROM MARCH LOWS

Exhibit 1: Investment-grade hard currency EMD outperformed high yield.

December 31, 2019– July 15, 2020

Total Return %

Dec 312019

Jan 142020

Jan 28 Feb 11 Feb 25 Mar 10 Mar 24 Apr 7 Apr 21 May 5 May 19 Jun 2 Jun 16 Jun 30 Jul 15

Sources: Franklin Templeton Capital Market Insights Group, JP Morgan, Macrobond. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results. Important data provider notices and terms available at www.franklintempletondatasources.com.

JP Morgan EMBI Global Diversi�ed

Fed announces unlimited asset purchases and support for corporate debt markets

JP Morgan EMBI Global Diversi�ed Investment GradeJP Morgan EMBI Global Diversi�ed High Yield

-30%

-20%

-10%

0%

10%

20%

CHINA’S GROWTH ENGINE RECOVERS

Exhibit 2: Industrial growth outshines consumer spending to drive GDP.

January 1, 2017– June 1, 2020

Percent

Jan2017

Apr Jul Oct Jan2018

Apr Jul Oct Jan2019

Apr Apr JunJul Oct Jan2020

Sources: Franklin Templeton Capital Market Insights Group, National Bureau of Statistics, Macrobond. Important data provider notices and terms available at www.franklintempletondatasources.com.

Industrial ProductionDomestic RetailGDP

15%

10%

5%

0%

-5%

-10%

-15%

-20%

-25%

3 Emerging market debt rallies on a wave of liquidity

Gauging a sovereign’s ability to meet its debt obligations also requires knowing the scope of any pre-existing conditions. Although Russia entered the pandemic with modest debt-to-GDP levels, many frontier economies have limited fiscal or monetary breathing room—half of these countries in the JP Morgan EMBI Global Diversified Index may need to restructure their debt before reaching a more sustainable path.

As highlighted in Exhibit 1, high-yield EMD still has some room to recover, and that’s good news as we believe spreads remain attractive for individual sovereigns. With liquidity support from the International Monetary Fund (IMF) and debt freezes by creditors like the World Bank or the Paris Club, some distressed sovereigns should have the wherewithal to avoid a solvency crisis. But not all debt freezes are the same. Consider the G20’s Debt Service Suspension Initiative (DSSI). Member G20 countries could forego principal and interest payments through this year and possibly into 2021. The program has raised concerns among sovereign finance ministers who point out the G20 implicitly expects private debt holders to freeze debt on the same terms. In a published op-ed in the franco-phone newspaper Jeune Afrique, 16 finance ministers made the case that G20 debt relief should not interrupt repayments on publicly traded bonds.1 Doing so could jeopardize their access to global capital markets and hamstring future economic growth.

For countries like Angola, successfully recovering from this year’s oil shock involves their lending relationship with China. So far this year, China has suspended debt repayments for 77 emerging economies and announced US$2 billion in assistance to countries impacted by COVID-19.2 For China, offering debt relief can enhance its reputation and global influence at a time when the United States is turning inwards. Before exploring China’s role as lender more deeply, it is important to review the supply-and-demand dynamics impacting oil prices.

OIL SUPPLY AND DEMANDThis year’s slide in oil prices first gained momentum in February when it was clear that China’s COVID-19 outbreak was obliterating demand from the world’s biggest crude oil importer. The slide picked up more steam in March after Saudi Arabia abandoned attempts to limit oil supply through its OPEC+ consortium, shattering its alliance with Russia. When stunned OPEC+ members finally regrouped, they agreed to record oil production cuts to buttress oil prices. So far, these cuts plus evidence of economic recovery in the United States and China have yielded results: Oil prices rebounded through June, as shown in Exhibit 3.

From the supply side, we believe oil prices should remain in the US$40 range for two reasons. First, OPEC+ is operating under a doctrine of mutually ensured destruction. If a member country breaks its curtailed production quota, fellow members—especially Saudi Arabia—can flood the oil market to the detriment of all. Second, swing production from shale oil producers in Canada and the United States is unlikely near term, as current oil prices are pushing the high-cost fracking industry to consolidate.

For now, the biggest wild card is not oil supply; instead, it is the sustainability of resurging demand amid second COVID-19 waves. Thus far, China’s blueprint of rapid and surgical virus containment (not blanket lockdowns) offers the best path toward reigniting global economic growth. It is important to note, however, that China’s V-shaped recovery is (for now) tilted to industrial output, fixed asset investments and capital expenditures—all levers that China’s government controls. That is not a problem for commodity-exporting countries like Zambia and Angola, which primarily benefit from China’s demand for industrial commodities.

4 Emerging market debt rallies on a wave of liquidity

ANGOLA’S DEBT FORBEARANCEAs one of Africa’s largest oil exporters, Angola was hit hard by this year’s collapse in oil prices; over 60% of state revenue and 90% of Angola’s exports are petroleum-based. Coming into the COVID-19 pandemic, Angola was already in a weakened position as its oil production had been declining due to aging oil fields, and public debt tipped over 100% of GDP, driven partly by the depreciation of its national currency, the Kwanza.

On the plus side, Angola’s macroeconomic reforms—part of a US$3.7 billion IMF program it entered in 2018—gives some investors confidence the economy is moving in the right direction.3 Aiming to privatize state-owned companies, Angola has made progress in fiscal consolidation (curbing expenditures and increasing revenues through a luxury tax, for example) and implementing a floating exchange rate for the Kwanza. All combined, a bottom-up analysis placed Angola in the fixed income team’s third-tier risk category at the start of 2020, which limits Angola exposure to a maximum of 4%. By contrast, allocations to countries to the first-tier risk category can reach a maximum of 16%.

On the heels of plunging oil prices and a ratings downgrade in late March, Angola’s bond prices signaled a debt restructuring was imminent. Many nervous investors headed straight for the exits. For those taking a closer look at Angola’s chief export partner and lender (China imports most of Angola’s oil) a different picture emerged. While the bulk of Angola’s long-term debt is in publicly traded 10- and 30-year bonds, its short-term debt is largely through China. As of this paper’s published date, President Joao Lourenco announced he has successfully negotiated a three-year debt moratorium on the US$22 billion Angola owes China, potentially saving US$4.5 billion in debt servicing costs.4 Bond markets responded favorably.

While oil prices in the US$40 range are still uncomfortable for Angola, its revised 2020 budget pegs its fiscal breakeven oil price at US$33. As for Angola’s negotiated debt freeze, it points to China’s growing influence in international finance. While the IMF still plays a key role in emerging economies—the IMF has roughly US$200 billion of outstanding commitments to countries like Argentina, Iraq and Ukraine5—China’s role as a creditor now surpasses the IMF and the World Bank, with an estimated US$1 trillion in direct loans and trade credits mostly to commodity-exporting economies in Africa, East Asia and Latin America.6

OIL PRICES RECOVER ON PRODUCTION CUTS

Exhibit 3: Brent crude oil price (USD per barrel)

December 31, 2019– July 15, 2020

Price

Dec 312019

Jan 142020

Jan 28 Feb 11 Feb 25 Mar 10 Mar 24 Apr 7 Apr 21 May 5 Jun 30 Jul 15May 19 Jun 2 Jun 16

Source: Franklin Templeton Capital Market Insights Group, Bloomberg. Past performance is not an indicator or a guarantee of future results. Important data provider notices and terms available at www.franklintempletondatasources.com.

$80

$70

$60

$50

$40

$30

$20

$10

5 Emerging market debt rallies on a wave of liquidity

IRAQ’S LOW-COST OIL PRODUCTIONIn our view, Iraq entered this year’s oil shock on better footing than many oil-exporting peers, including Angola. After restructuring its Saddam-era debt in 2003, Iraq kept debt burdens low by relying on foreign oil companies to boost production of its oil reserves, rather than borrowing money to accomplish those aims on its own. As a result, Iraq spent less than 3% of its state revenues on debt interest payments last year.7 Given its strong fiscal position, Iraq resides in the team’s second-tier risk category (limiting exposures to 8%) with risks stemming mostly from Iraq’s ongoing conflicts with the Islamic state.

To put the quantity of Iraq’s current oil production in context, between the 2003 US invasion and 2010, oil production veered between less than half a million barrels per day (bpd) and barely 2.5 million bpd. By contrast, last year Iraq produced a record-setting 4.8 million bpd—making it OPEC’s second-largest oil producer—and marked a major milestone after 15 years of conflict.8

With its low-cost oil production and access to 12% of the world’s oil reserves, Iraq remains one of the world’s strongest oil producers, especially compared with shale oil producers in the United States. One hiccup this year has been adhering to OPEC’s production restric-tions—Iraq admitted it had not reduced its daily production by 1 million bpd as promised and has agreed to reduce it from July–September 2020.9 Iraq’s big hurdle, however, is not OPEC’s production quotas; it is the government’s vast public payroll and state pensions.

Iraq’s new finance minister, Ali Allawi, points to a monthly wage bill of US$5 billion and notes Iraq needs US$58/barrel oil prices to meet wage and pension obligations.10 Considered one of the best economic minds in Iraq (Allawi was educated at Harvard and MIT) Allawi has signaled a major restructuring of Iraq’s economy is in order, carried out amidst an environment of growing civil unrest and a rising poverty rate.11 Whereas Angola turned to China for debt relief, it is likely Allawi will turn to both the United States and the IMF for budgetary support, giving him room to implement a comprehensive package of economic reforms.

TIP TOE BACK INTO YIELDAs the world looks forward to COVID-19 vaccines, emerging market assets should continue their upward trajectory as economies and consumers return to business as usual. During the recovery phase after a global shock, EMD investors who rushed for the exits typically tip toe back into EMD, first adding exposure in investment grade hard-currency sovereigns, before graduating to high yield and then local currency bonds. We believe a selective approach that evaluates bonds country by country remains the best approach for emerging market debt investing.

6 Emerging market debt rallies on a wave of liquidity

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies. Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a governmental entity may be unwilling or unable to pay interest and repay principal on its sovereign debt. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline.

Endnotes1. “Aucun pays ne doit avoir à choisir entre sauver des vies et rembourser des dettes,” Jeune Afrique, May 2020.2. “China suspends debt repayment for 77 developing nations, regions,” Global Times, June 2020.3. “IMF Executive Board Approves US$3.7 Billion Extended Arrangement Under the Extended Fund Facility for Angola,” International Monetary Fund, Press Release, December 2018.4. Frey, A. “Angola/Mozambique: China debt relief helps Fitch Ratings,” Club of Mozambique, June 2020.5. “Weekly Report on Key Financial Statistics,” International Monetary Fund, March 2020.6. Horn, S. Reinhart, C. Trebesch, C. “How Much Money Does the World Owe China?,” Harvard Business Review, February 2020.7. Iraq Staff Report. International Monetary Fund, July 2019.8. Turak, N. “Iraq is pumping record oil, creating a ‘fully-blown migraine’ for OPEC’s cutting plans,” CNBC Markets, September 2019.9. Smith, G. Wardany, S. Blas, J. “OPEC+ Finalizes Deal on Compensation for Iraq Cuts Cheating,” Bloomberg, June 2020.10. Iraq Economic Monitor, Navigating the Perfect Storm (Redux), World Bank Group Spring 2020.11. Cornish, C. “Iraq warns economic woes could stoke insecurity,” Financial Times, July 2020.

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