Increased geopolitical risk, stemming from renewed military action in Iran, has severely impacted emerging market (EM) credit due to a broader risk-off environment and a spike in energy prices, according to a latest ING Group report.
Specifically, Gulf Cooperation Council (GCC) sovereigns are experiencing pressure from the heightened regional instability, the report claimed.
Recent Middle East events have significantly spiked energy prices, with Brent crude rising above $85 per barrel from below $70 in mid-February and $60 in late December.
Energy price spike divides EM exporters and importers
This divergence has implications for emerging market sovereigns, particularly large energy importers that are likely to face higher inflation and deteriorating external balances.
Countries in Central and Eastern Europe — including North Macedonia, Serbia, Hungary, and Turkey — are among those with significant exposure.
The same applies to African frontier sovereigns such as Zambia and Senegal, as well as Latin American economies including Panama and El Salvador.
Pakistan also falls into this category due to its large energy deficit.
These countries are particularly vulnerable to shifts in energy prices and supply conditions, according to James Wilson, emerging market sovereign strategist at ING Group, in a recent report.
“The flip side of this dynamic, of course, is that oil exporters generally should benefit from the spike in prices,” Wilson said.
Oman, Kuwait, and Qatar generally possess a significant net fuel surplus, exceeding 30% of their GDP.
However, the potential security risks inherent in the region for these nations are likely to negate the economic advantages derived from higher oil prices.
As a result, investors are likely to view oil exporters outside the immediate region as potential beneficiaries of higher oil prices, Wilson added.
These include African nations such as Angola, Gabon, and Nigeria, as well as Kazakhstan in Central Asia.
Source: ING Research
GCC regional impact varies; sentiment weakens
In the GCC country group, the typical correlation between oil prices and sovereign risk premium has recently weakened.
Despite the surge in oil prices, GCC sovereign spreads have widened relative to Investment Grade peers, according to the report.
This divergence is occurring against a backdrop of regional tensions, including Iran’s retaliatory actions against military bases and oil/refinery facilities across the GCC, which also raise concerns about the safety of tanker traffic and, consequently, export routes.
The impact is not uniform across the GCC. Bahrain is the most credit-vulnerable due to a much weaker balance sheet and deteriorating fundamentals, contrasting sharply with Oman’s improved position and return to investment-grade rating last year.
Oman is the region’s most openly neutral country, calling for de-escalation despite facing drone attacks.
It seems less reliant on the Strait of Hormuz for exports than Qatar, which depends heavily on the Strait for LNG, Wilson noted.
Source: ING Research
Meanwhile, the UAE is facing significant economic consequences, primarily through disruptions to its key sectors: tourism, travel, and transit.
These challenges are compounded by a difficult period for its hard currency bonds, stemming from the nation’s removal from JP Morgan’s EMBI bond indices.
This removal, however, is essentially due to the UAE “graduating” from emerging market status.
The primary risk for Saudi Arabia is disruption to its energy infrastructure; however, the country is partially mitigated by the availability of potential alternative export routes through the Red Sea, Wilson noted
Risk-off sentiment could reverse EM mood improvement
Globally, the strong dollar, higher yields, and risk-off sentiment are challenging EM credit markets.
While the impact depends on the military action’s length and severity, these developments follow a year of improved investor sentiment toward EM.
Source: ING Research
“We have seen broad-based inflows into EM assets since ‘Liberation Day’ last year, including strong portfolios generally into EM debt across regions to start the year,” Wilson added.
The strong momentum in primary issuance has understandably slowed recently.
Furthermore, a more lasting reversal of these inflows into EM remains a risk, particularly if the initial positive consensus surrounding the asset class seen at the start of the year shifts.
The broad tightening for EM credit has driven spread levels near all-time lows, significantly tighter than long-term averages across all rating categories before the latest volatility, according to the report.
Although the recent sell-off has been relatively orderly, it is only a minor fluctuation in the long-term outlook, according to Wilson.
Should the conflict escalate and global disruption continue, we anticipate a wider decompression of spreads from current levels.
Specifically, single-B spreads on higher-beta, frontier names could face significant risk, he added.
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