Expectations of rising US interest rates and the continuous appreciation of the US dollar both acted as headwinds for emerging market bonds over the past two years. Combined with domestic problems and weaker global growth, this led to negative returns for investors. But the removal of some of these headwinds against a backdrop of overly bearish sentiment has recently ignited a sharp turnaround rally.
Recent decisions by both the Fed and the ECB have been very positive in breaking the trend of tightening global liquidity conditions, which had come about through various transmission mechanisms. The Fed has acknowledged that US economic growth, as well as inflation, does not warrant the relatively aggressive monetary tightening that it had signalled to the market. This has stopped the US dollar’s relentless rise – at least for now – and gives the oil price room to extend its recent increase. Meanwhile, the ECB has continued to loosen its monetary policy, with its current policy mix less focused on a weak euro.
Various fixed income areas are benefiting from this development: These include inflation-linked bonds due to heightened inflation expectations, which had previously been highly correlated with the oil price. Credit markets have been a further beneficiary, with spreads tightening, which is supportive for emerging markets (EM). Finally, the dampener on the dollar has taken the pressure off the Chinese renminbi to devalue, which was a widespread investor worry. The Fed’s correction now more closely mirrors investors’ expectations of the trajectory of future US rate hikes.
Adding to the positive backdrop is that global growth appears to be picking up, following a string of disappointing economic data. The latest figures from the US, Japan and Europe are typically coming in above expectations. Nevertheless, our view is that we will remain in a long-term low-growth environment, with demographics, low productivity and high debt levels in certain areas keeping growth subdued.
The key factors for EM to start performing again this year were cheapening valuations alongside sentiment becoming extremely negative towards all EM asset classes. The fact that the asset class remains very under-owned in investor portfolios means that the positive momentum could continue for a while. At the fundamental level, the rebalancing across economies also continues. This process will take time and a V-shaped recovery is unlikely. Countries are at different stages in this cycle, with Central Europe far advanced, while Brazil has just embarked on it. But even latecomer Brazil is now on a progressive path, with its trade balance turning positive. It is helped by the cheaper currency and is one of the few countries in Latin America where exports in volume terms are increasing. Hence, Brazil is currently among our favourite trades. The political uncertainties around a possible impeachment of president Rousseff remain a risk, but we foresee no further significant downside from that area the as attractive valuations and improving fundamentals remain the main drivers.
Central and Eastern European economies have emerged stronger following the rebalancing, which leads us to hard currency bonds (we think that local currency bonds are expensive) and currencies in these countries. We are also more positive again on Mexico, after assets there had been severely punished in the wake of disappointing US data. We like both the currency as well as peso-denominated debt, especially at the longer end of the yield curve.
We have become relatively more optimistic on emerging compared to developed markets in recent months. Despite the challenging economic backdrop and some remaining negative sentiment, we believe that attractive valuations and investors’ underweight in EM should form a solid base for further progress from here. Some stability in commodity and oil prices should help to increase confidence. Very high yields in some markets, such as Brazil, could finally attract buyers that were waiting on the side-lines for an entry point.