Early 2018 forecasts of a return of volatility after two years of near-somnolent developed markets seem to prove more prescient with every passing month, with significant implications for emerging-market assets.
Yields in core markets began taking off early in the year. In the US, wage growth, improving employment and expectations of the US Federal Reserve’s (Fed) rate rise propelled 10-year Treasury yields to a multi-year high. The rate increase bolstered yields further, while President Donald Trump’s trade hostilities, and the subsequent Chinese responses, drove money into traditional safe havens, with 10-year Treasury yields hovering around 3%. Strong signs that the US economy is on an upswing, and anxieties about geopolitics and trade continue to simmer and affect Asian markets.
After such a prolonged period of stagnation during which global capital poured into Asian assets in search of yield, local debt is inevitably seen as vulnerable in this environment.
Outflows from Asian debt began in April 2018 and have not abated since. Spreads on emerging-market (EM) bonds are hovering near a two-year high over Treasuries, propelled by trade fears, a higher dollar and tighter liquidity. Rising oil prices are threatening to swell the current account deficits of major importers like Indonesia, India and the Philippines while many Asian currencies have been in decline – notably Indonesia’s rupiah, the Philippines peso and the South Korean won, while the region’s stock markets hit a collective nine-year low in early July, as the first round of US tariffs loomed.
Asian debt continues to hold up well
It’s not all gloom for government debts. For one thing, the global economy is doing quite well, and the flight from emerging markets has not been as bad as portrayed.
Asian debt holdings are still equal to the long-term average, which may indicate a resilient demand, and although local-currency bonds have lost value, they are still higher than they were a year ago.
Much of the focus fuelling volatility has been on the potential damage of a US-led trade war, but the prospect of Asian markets becoming less dependent on the US may buoy sentiment in the long term. Trade growth in Asia is the fastest in the world, and a trade war could accelerate a shift in trade corridors for the benefit of some Asian economies.
Indeed, Chinese government debt has been a beneficiary of the trade conflict, even as stock markets and the currency tumbled. In June, foreign investors bought Chinese sovereign bonds at the fastest rate in almost two years, and the yield on 10-year notes reached a 14-month low of 3.47% in early July. Any escalation of the trade war could lure risk-averse foreign capital into bonds at an even faster rate, and with the Chinese government committed to supporting the currency, the danger of the yuan tumbling further is relatively limited.
Where from here?
After a stellar run in 2017, Asian local-currency debt faces headwinds as many of the conditions that enabled that run have started to weaken.
Nevertheless, while investors will need to be a lot more cautious, the outlook remains positive. Yields are still in a reasonable range, with credit spreads having moved up as much as 60 basis points this year. EM local currency debts still provide investors with a healthy spread over US Treasuries with a lower US interest-rate risk than hard-currency bonds.
Many EMs issue debt in their local currency, as opposed to hard currency, much of which is held by domestic investors, making it less subject to the vagaries of international flows, and less sensitive to US dollar moves.
With weak capital flows and political uncertainty in Europe unlikely to abate soon, the dollar is likely to continue to strengthen this year. Despite short-term macro risks such as a strengthening dollar and the potential for further trade turmoil, we prefer local currency over hard currency EM debt.
According to State Street’s measures of fair value, this represents an opportunity in local debts given Asian currencies are about 5-6% undervalued against the dollar. Since much Asian debt is held by local investors, this makes it less vulnerable to international flows, and with account balances generally healthier than before the global financial crisis, the risk of contagion from troubles in Turkey or Brazil is lower than before.
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