As the end of the year draws nearer, 2018 will likely to be characterised as a challenging one for emerging markets (EM) bonds.
In recent months, it has been the turn of global emerging market bonds to experience unsettling bouts of volatility, driven by a number of macro developments, including US rate hikes, a strong US dollar, tighter monetary policies globally, escalating trade tensions, and potential contagion from Turkey and Argentina. All these factors are seemingly unfavourable to EM bond markets.
OUTPERFORMING EM PEERS
Despite the undeniable gravity of some issues facing certain emerging market economies, taking a closer look at the EM bond markets reveals Asian bonds outperform their EM peers year-to-date1 when markets are challenging. This is due to the fact that they offer lower volatilities and better return/risk ratios. The attractions of investing in local currency debt are still apparent in Asia, which has been relatively insulated from events developing elsewhere.
While investors’ risk appetite had a clearer direction in 2017, so far in 2018, it has alternated between risk-on and risk-off. Investors shifted into cash, and allocations to equity, fixed income and multi-asset funds decreased, while allocations to money market funds increased year-to-date.
In State Street Global Advisors’ view, US dollar movements and volatility will remain the key risks for EM bonds in the near term. The US dollar is likely to be underpinned by further monetary tightening from the US Federal Reserve, with an additional rate hike expected in December and another three to four increases anticipated in 2019.
It’s likely that the current period of quantitative tightening to run for a while yet – especially given that Europe, Japan and the UK are so far behind the US in their progression towards tighter conditions – but we do expect interest rates to peak at a far lower level than in previous cycles. This means the higher yields on offer in Asian market debt can remain relatively attractive.
Other risks include issues bedevilling countries such as the Philippines, Turkey and Argentina which are not going to vanish overnight. Although the escalating global trade dispute between the US and China is cause for concern, the recent agreement on a new version of NAFTA between the US, Canada and Mexico offers some cause for optimism.
INTACT IN THE LONG-TERM
In the past, shake-outs in EM bond and equity markets were short and sharp, followed by a long and gradual recovery. In a rush for the exits, indiscriminate selling has typically pushed entire markets down, and this has been particularly evident in EM bonds because of the perception of higher risk. This, in turn, has created opportunities for vigilant long-term investors.
Overall, the fundamentals of the EM story have remained mostly unchanged. For Asia in particular, strong secular economic growth rates, favourable demographics, better fiscal positions and improving credit ratings all remain intact.
For shrewd investors prepared to take a longer-term view, recent upheavals may present an opportunity. EM currencies are beginning to look undervalued against the US dollar, and yield spreads have spiked higher, offering an attractive entry point.
Following the global financial crisis, very few investors had the nerves to invest in EM bonds, but those who did were richly rewarded.
Within the EM debt universe, for example, Asian local currency bonds are certainly more stable than bonds from some Latin American countries and carry many of the same attractions but fewer of the risks. Asian economies are now more rigorously sandbagged, and less vulnerable to the disruptive forces that have beset them over the past few decades. Economic growth and reforms have produced better functioning markets that, importantly, are now less reliant on overseas investors to fund deficits.
Investors in emerging market debt have a choice of hard or local currencies. Some have expressed concern over foreign exchange, worried that the biggest uncertainty in the local currency space is currency. Historically, currencies have been a significant contributor to Asian local currency bond returns, as represented by the iBoxx ABF Pan Asia Index, with annualised currency returns since January 2001 having contributed 1.61% to the total Asian local currency bond return2. In State Street Global Advisors’ view, local currency investment may offer the potential to fully benefit from growing Asian economies by capturing both bond market returns and currency gains.
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1. Source: Bloomberg, as of 31 August 2018
2. Source: Markit iBoxx ABF Pan-Asia Index, as of 30 September 2018. Index returns reflect capital gains and losses, income, and the reinvestment of dividends. Past performance is not a guarantee of future results.
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