The unrest in the Middle East has affected Emerging Market Debt (EMD) through rising rates and higher risk premiums. There is no indication, for now, of a structural deterioration in credit risk.
That is according to senior portfolio manager Anthony Kettle of RBC BlueBay Asset Management in an interview with Investment Officer. He states that the main impact of the conflict currently stems less from geopolitics itself and more from its transmission into inflation and interest rate markets. The JP Morgan Emerging Market Bond Index (EMBI) has a relatively long duration and is therefore sensitive to rate movements.
“You have effectively seen a double hit: spreads have widened while bond yields have risen at the same time. In particular, the increase in US Treasury yields had a significant impact. That rate move has been more painful for investors than the widening of risk premiums,” Kettle said.
The EMBI index lost slightly more than 2,5 percent in March, with the Middle East underperforming somewhat at around 3,2 percent, compared with Latin America, where losses were limited to approximately 1,9 percent.
The Middle East’s share in the EMBI index has grown in recent years to around 20 percent. This makes the asset class more sensitive to geopolitical tensions in the region. “But geopolitical risk is not exclusive to the Middle East,” Kettle noted. “We also see it in Latin America, Russia-Ukraine, and around China-Taiwan. The generally higher AA or A credit quality of many countries in the Middle East acts as a mitigating factor.”
In local currency markets, the impact of the Middle East is smaller. The region represents only about 7 percent of the local EMD index. However, rising bond yields and a strong dollar are affecting this market as well, Kettle said.
Differences between countries
Within the Middle East, Kettle sees clear differences. Bahrain in particular is under pressure due to weaker debt indicators and economic vulnerability. “Bahrain is likely the most vulnerable given its debt position. The country has historically also required support from neighboring countries.” Other countries, such as the United Arab Emirates and Qatar, were mainly affected by rising rates and less by widening spreads.
According to Kettle, there is currently no reason to assume that credit risk in EMD has structurally increased. “Credit risk is not higher than before, at least not on a structural basis.” Only in a scenario involving prolonged escalation could fundamentals truly deteriorate.
“In a tail-risk scenario involving a prolonged conflict, you could see lower government revenues and pressure on budgets. In that case, credit quality could indeed deteriorate.” He also points to indirect economic effects. “A sector like tourism is vulnerable. Less tourism and lower immigration could, for example, affect sectors such as real estate.”
At the same time, Kettle expects governments in the region to step in if economic damage increases. “You can expect governments to support their economies once greater stability returns.”
A possible long-term effect, he added, is that energy-importing countries may further reduce their dependence on the Middle East. “Just as Europe diversified its energy sources after the war in Ukraine, Asia could do the same in response to increased geopolitical risks.”
Effective yields rise
The question is whether the recent increase in risk premiums is temporary or more structural. According to Kettle, part of the increase is likely to persist. “If a resolution is reached, risk premiums will partially decline. But it is unlikely that spreads will return to the absolute lows seen before the conflict.”
He expects spreads may remain around 10 basis points higher than before, depending on the geopolitical outcome. At the same time, the correction has pushed effective yields on EMD to a clearly more attractive level. The average yield has risen from approximately 6,6 percent to around 7,2 percent.
“Spreads are not necessarily extremely attractive, but yields have clearly improved. Ultimately, that is what many investors focus on,” Kettle said. This may create opportunities over time, although he believes it is still too early to add risk aggressively. “If the situation stabilizes, interesting opportunities could emerge. But for now, uncertainty remains relatively high.”
Winners and losers
According to Kettle, current market conditions mainly underscore the importance of active positioning within emerging markets. The impact of the conflict is clearly dividing emerging markets into winners and losers.
Energy-importing countries are being hit the hardest. Asian countries such as the Philippines, Thailand, and South Korea are vulnerable, both due to higher oil prices and potential constraints in gas supply. In Central and Eastern Europe, Hungary in particular is facing a significant repricing of rates.
On the other side are energy-exporting countries such as Brazil, Angola, and Nigeria. “If you need to take positions somewhere, these are the countries showing greater resilience,” Kettle said. Latin America also benefits from its greater geographical distance from the geopolitical epicenter. Turkey, by contrast, remains vulnerable due to its reliance on energy imports.
The biggest risk for EMD investors ultimately lies not in geopolitics itself, but in the potential macroeconomic consequences, Kettle stated. “The key question is how persistent the inflation impact will be and whether that ultimately leads to a broader slowdown in growth.” He also warned of a scenario in which higher inflation coincides with weaker growth.
“If shocks feed through via energy, industry, and supply chains, you could see a more stagflationary environment. That is not the base case, but it is a risk to take into account. Although it is still too early to say, this is also one reason why Trump will, sooner or later, have to find a way out of this conflict.”