Kevin Daly is a portfolio manager on Aberdeen Asset Management's emerging-market fixed-income team, having joined the firm in 2007. He spent the previous 10 years at rating agency Standard & Poor's in London and Singapore, where he worked as a credit market analyst covering global emerging markets and then in the sovereign ratings team as head of marketing and origination.
Historically, the bond market usually enters a short correction six months before interest-rate hikes. When do you expect the US Federal Reserve to raise interest rates? Do you think the correction will present a good opportunity for investors?
If you go back to 2004, the last time the Fed commenced on a rate-tightening cycle, the market sold off three months before the first rate hike. US Treasury yields spiked up and emerging-market [EM] spreads widened by around 100 basis points. It's unlikely we'll see a similar reaction once the Fed comes back into play, which is likely to happen in the third quarter.
The big difference between this cycle and 2004 is that, back then, the neutral rate on Fed funds was 5.25%, whereas we would expect it to be around 2% by the time the Fed is done hiking in 2011. Hence, the market reaction should be a little less severe in 2010 than in 2004.
If we do get a correction, we would view this as a good buying opportunity, as the fundamental story in EM remains constructive and the outlook is more favourable compared to the fiscally impaired and highly indebted developed countries.
Is the recent slowdown in the rally in EM debt and high-yield bonds an accurate reflection of uncertainties in the sustainability of economic growth?
The slowdown we saw between mid-January and mid-February was mainly driven by concerns about Greece, and to a lesser extent by the gradual removal of stimulus in China. But the market is now moving on, reflecting the reduced risk of a Greece blow-up. Meanwhile, the global macro outlook continues to improve, led by improving US data. The EM growth outlook remains robust, which should be supportive for EM debt until the Fed comes back into play.
Which emerging market are you the most optimistic about and why? Are you more confident about Latin America debt or Asia debt, and what are the underlying risks for both regions' debt?
We don't have any strong regional views, but we do have some key conviction plays. In Asia, that would be Indonesia, which we think will get to investment grade in the next few years. Growth should be in the 5-6% range in 2010, after posting surprisingly strong figure of 4.5% in 2009, the fiscal deficit is one of the lowest in the world at 1.5%, debt-to-GDP is now around 30%, which compares well to its regional and rated peers, and the political outlook continues to improve. We think local-currency debt and some of the corporates -- mainly coal-related companies and utilities -- offer the most attractive opportunities.
In Latin America, we like Mexico, which should benefit from an improving domestic and US growth outlook. In particular, we like the Mexican peso, which lagged the rally in EM currencies in 2009, and some corporates, in particular in the low-income housing sector.
In emerging Europe, the Polish zloty remains attractive. Poland was the only country in Europe to post positive growth in 2009, and should see growth of 3-4% in 2010. Despite the improving growth outlook, the zloty continues to trade below its five-year real effective exchange rate.
What variables and economic indicators other than interest-rate hikes should bond investors look out for this year?
Inflation will remain a key risk in emerging markets in 2010. With growth picking up and expected to be around 6%, up from around 4% in 2009, we will see inflation pressures rising during the year. The market is already pricing in a number of rate hikes, with Brazil the most notable, pricing in over 300bp. The most recent inflation survey forecasts prices to rise 5% this year, which is above the central bank's 4.5% target, but all in all we don't think we'll see inflation much higher than 5-5.5%, which should be supportive for our local rate position.
But if inflation expectations deteriorate further, prompting the central bank to tighten more aggressively, local rates could suffer. If this scenario plays out in other countries, it could be a difficult year for local-currency debt. Weakness in local rates may, however, be partially offset by FX appreciation, with central banks likely to tolerate more FX strength to mitigate some of the inflation threat.
Interest hikes may have a big impact on developed-market bonds. However, would such hikes also have a negative impact on emerging market debt as well?
As highlighted earlier, if the Fed comes into play in 2010 we will see US Treasury yields much higher than today, with the 10-year pushing well above current 3.7% level, which in turn will weigh on other fixed-income markets, including EM debt.
As for rising local rates, as noted above, the market is pricing in ample rate hikes in a number of countries, so we should not see a negative reaction in local rates unless the unexpected happens -- more aggressive than expected tightening, central banks falling behind the curve in the face of rising inflation, or another bout of risk aversion, prompting a move out of risk assets into US dollars and US Treasuries.
Although the outlook for high-yield bonds and EM bonds remains promising, is it true that yields as high as last year are unlikely to repeat again this year?
Yes, we can safely say that we will not repeat 2009 performance this year. Going into last year, the market was extremely negative, pricing in an excessive degree of default risk, but as fears of another great depression eased and confidence improved, investors increased their exposure to high-yielding countries, where default risk remained low.
Heading into 2010, high-yield opportunities remain fairly limited to the likes of Argentina and Venezuela, so a repeat of 2009 returns is not on the cards, but a year of solid double-digit returns is a high probability, especially if the Fed remains sidelined this year.