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EM Sovereign Credit Monitor Summary

Core Content

This document provides an analysis of Emerging Market (EM) sovereign credit spreads and investment strategies, highlighting the impact of recent macroeconomic and geopolitical developments on EM credit valuations and risk profiles.

Main Points

• Revised Spread Target: The 12-month EM hard currency sovereign spread target has been revised downward by 100 basis points (bps), from 500bps to 400bps, due to the de-escalation of US-China trade tensions and the resulting improvement in global risk sentiment. This reflects a more optimistic growth outlook and lower recession probability.
• Current Spread Levels: As of the latest data, current spreads are around 331bps, still wider than the initial 12-month target of 350bps at the start of the year. The document suggests that while spreads have retraced from their April widening, they remain above the target, implying further potential for tightening.
• Defensive Strategy: Despite the revised target, the outlook remains defensive due to high recession odds and elevated uncertainty regarding US policy and hard data deterioration. The recommendation includes screening for sovereigns with low sensitivity to US growth and rate volatility shocks, and protection against oil price declines.
• Preferred Longs: The report recommends long positions in the sovereign USD bonds of Poland, Hungary, Uruguay, and Jamaica, as a carry trade basket. These countries are considered attractive based on their yields, fundamentals, and spread sensitivity to US shocks.
• Valuation Dynamics: EM sovereign spreads have experienced a short-lived widening in April, which led to a valuation reset. However, with the recovery in risk sentiment, spreads are expected to tighten further.
• Left-Tail Risks: The analysis includes a look at the probability of default and debt distress, with the highest risk for B- or lower-rated sovereigns. The document also highlights external funding requirements, which are a critical factor in assessing sovereign credit risk.
• Frontier Currencies: Frontier currency valuations are measured against the USD using the GSDEER framework, indicating potential for value in certain markets.
• Issuance Trends: EM sovereign USD bond issuance has slowed in recent months but is expected to pick up as macroeconomic conditions remain stable. The total gross issuance for the year is forecasted to reach around $150bn, up from $130bn.
• Maturity Profile: The maturity profile of EM sovereign bonds shows a concentration of short-term and medium-term maturities, with a focus on managing liquidity and interest rate risk.

Key Information

• Recession Probability: Reduced from 45% to 35% due to trade tensions easing.
• Spread Target: Revised to 400bps from 500bps, reflecting a more favorable outlook.
• Preferred Longs: Poland, Hungary, Uruguay, and Jamaica are recommended for their relatively wide spreads and strong fundamentals.
• Carry Strategy: Emphasis on carry in long positions, similar to strategies used in Developed Markets (DM) and Asia.
• Oil Price Sensitivity: Oil exposure is a key factor, with countries like Colombia, Bahrain, and Oman offering protection against further oil price declines.
• Valuation Reset: Spreads have retraced from April's widening, returning to historical tight levels, but the document anticipates a reversal if market conditions change.
• External Funding Requirements: For HY sovereigns, these are calculated as the sum of current account deficit and short-term external debt, relative to FX reserves.
• Model-Implied Valuation: The GS EM Sovereign Credit Model links spreads to macro fundamentals and market volatility, with the model showing that current spreads are relatively fair.
• Macro Thematic Factors: These include GDP growth, inflation, public debt, external debt, current account, FX reserves, and governance indicators, all of which influence spread dynamics.
• Statistical Model: A fixed effects panel regression model is used to assess the relationship between macroeconomic variables and bond spreads, with robust standard errors and a high adjusted R-squared.

Investment Recommendations

• Go Long: Poland, Hungary, Uruguay, and Jamaica as an equally weighted basket, with a total return target of 3% and a stop loss at -1.5%.
• Underweights: Dominican Republic, Brazil, Turkey, and Jordan are recommended for protection against US growth and rate volatility shocks.
• Avoid: Nigeria due to its vulnerability to oil price shocks, while Angola's spreads are considered more resilient.

Conclusion

The report suggests that while EM sovereign spreads are expected to tighten further, the environment remains uncertain and defensive strategies are still appropriate. The recommended basket of longs offers a balance between carry generation and protection against macroeconomic shocks, particularly those related to US policy and oil prices.