EM local currency bonds start 2017 much like they did 2016: yields are again close to 7%, and investors are underweight the asset class once more.
This nervousness among investors was more understandable 12 months ago when global growth was weak and the asset class had suffered three years of sub-par returns. Now, EM local currency bonds are up 14% year-on-year1 and the global growth cycle appears to be turning. We believe the themes that drove the rally in 2016 are relevant once again in 2017.
The 2016 recovery was, in our view, based on two fundamental themes: 1) balance of payments adjustment and 2) recovering growth.
Emerging market current accounts improved steadily after the Taper Tantrum in 2013, but capital outflows ensured that EM’s balance of payments was in deficit, FX reserves fell, and EM currencies weakened.
By early 2016, capital outflows had reached fairly extreme levels. As soon as they stabilised, continued gains in the current account meant that EM’s balance of payments returned to surplus, and EM FX reserves started to rise.
Similarly, EM credit growth fell from 2011 to 2015, the credit impulse was negative and EM GDP growth was weak. Credit growth reached historically low levels by early 2016. As they started to stabilise, the credit impulse rebounded and both rising PMIs and recovering car sales suggested that EM growth was strengthening.
As is generally the case, these twin themes of rising FX reserves and stronger growth caused EM currencies to rally, and, by October 2016, the EM local currency asset class was up 16% calendar year-to-date. All this came to a halt, however, with the election of Trump to the US presidency.
The election impact was immediate: By our estimates, the fourth-quarter portfolio outflow from EM was the largest since 2008, bringing an inevitable correction in EM FX in its wake.
This derailed both recovery themes, at least temporarily. The sharp capital outflows caused EM FX reserves to fall, and the tightening in credit conditions probably caused the credit impulse to turn negative. EM car sales fell in November. The reversal of these themes caused local currency bonds to fall 7.5% in November alone.
But while Trump’s policy changes, in particular the increase in trade barriers, might prove tough for specific EM manufacturers, it is by no means clear that they are bad for EM in aggregate. The proposed fiscal stimulus is likely to boost growth and support commodity prices, both of which are positive for EM.
The pace of outflows already appears to have softened. November’s USD 27 billion outflow was followed by a USD 3 billion outflow in December.
The fundamental drivers that made the recovery themes possible at the start of 2016 were 1) that EM portfolio outflows are already at extremes, and 2) that credit growth was already at its 2008/09 lows. The lower the starting levels of flows, the harder it is for them to fall further. EM remains vulnerable to volatile portfolio flows in the coming months, but as soon as these flows stabilise, reserves rise, the credit impulse improves and growth picks up, allowing the bullish themes that drove the 2016 rally to reassert themselves. We expect high single-digit returns from the asset class in 2017.
Both Mexico and Turkey have struggled of late, and local government bonds in these countries are down 20% over the past three months. It is easy to see how they could either collapse or recover strongly in the year ahead. We are inclined to look for bullish opportunities in the former and bearish opportunities in the latter. Getting these two calls right could turn a solid performance for the asset class into a spectacular performance for our funds.