Emerging market debt: what a difference a year makes (by Aberdeen)
2016 has been a year of surprises. Commodity prices kicked things off with a steep and unexpected drop before steadily rebounding. Then Brexit happened – or the vote did, at least. The political pandemonium has been prolonged since, with Donald Trump closing in on presidential rival and early-favourite Hilary Clinton.
Developed markets (DM) kept up their descent into the world of negative rates. Seventy per cent of DM government bonds now yield less than one percent, and 30% of those offer negative yields. The unconventional economic and monetary policy adopted by DM central banks has seen ‘lower-for-longer’ morphed into ‘lower-for-even-longer’. There are even embryonic noises of ‘lower forever’.
So what has this all meant for emerging markets (EM), and EM debt in particular?
In short, the asset class is once again the new haven for yield in a world of stagnant growth and rising political uncertainty.
According to JP Morgan data, EM local markets have returned 17.8% year-to-date (YTD), ahead of hard currency returns at +15.2%. Local currency returns have been bolstered by an improvement in foreign exchange (FX) performance, although inflows have overwhelmingly been into hard currency funds suggesting there is still some concern over the FX environment going forward.
Britain’s vote to leave the European Union counter-intuitively acted as a catalyst for investor flows into EM debt. Whatever the outcome, Brexit is likely to take a long time to finalise. This will ensure a level of political uncertainty, one that will be matched in Europe with the rise of populist parties on the right and left. All eyes are on the elections and referenda over the next year to see what gains those populist parties can achieve.
This in is contrast to what’s been going on in emerging markets where the politics has been largely calm. The replacement of Dilma Rousseff by Michael Temer and his highly capable team, while not universally popular at home, is popular among investors. Similarly, Argentina’s Mauricio Macri has enjoyed a positive start to his tenure since taking the helm last December, ending the 15-year absence from the international debt market.
Another key part of the turnaround is the way in which EM central banks have been very strict. On the whole, they have adopted orthodox monetary policies, something which their DM counterparts have failed to do as the unconventional becomes increasingly conventional. An example of this is the Bank of Japan using ‘shock’ tactics to push through its negative interest rates policy earlier this year; deny, then strike. The conformist approach adopted by EM central banks, however, has not only built up institutional credibility and cash reserves, but we’re seeing inflation begin to fall. This means policy makers now have the opportunity to start cutting interest rates, kick-starting growth as a result.
And there’s reason to believe that the EM macro-economic picture will improve further. The International Monetary Fund has forecasted GDP growth of +4.1% this year, rising to +4.6% in 2017. As a comparison, advanced economies are expected to see growth of just +1.6% this year, with no upside to this figure for 2017. China’s latest figures were remarkably resilient, too. There’s much to be cynical about when it comes to Chinese data but, even if they’re only half true, they show an improvement or stabilisation across all indicators.
Even a US rate rise in December should be manageable. That proved to be the case with the last hike which was nearly a year ago. The US Federal Reserve (Fed) remains ultra-conservative and it’s clear that the path of rates upwards will be extremely gradual whatever happens in December. In any case, the price of many EM assets already reflects an expectation that rates will rise again by the end of the year.
Still, it will be a concern if the dollar continues to strengthen given its potential to impact commodity prices and suck liquidity out of emerging markets. But its climb higher should be gradual given the glacial pace of Fed hikes.
When Donald Trump announced his candidacy for the 2016 presidential election last summer, no one could have anticipated the impact he’s had on US politics. Currency markets are seriously starting to ponder what the impact might be if Trump did cause an upset in November; the Mexican peso slumped to its lowest-ever level against the US dollar recently. In China, a Trump win has the potential to hit the economy hard, especially if the outspoken Republican slaps a tariff on imports as promised. Any slowdown in the US economy would also weigh on EM exports.
The large inflows into the asset class should not be taken as a sign of another breakout of these economies. Flows are as much an escape from low DM yields. Nonetheless, we are a long way from where we were a year ago and there’s good reason to be positive about the year ahead.
Kevin Daly
Senior Investment Manager, Fixed Income – Aberdeen AM
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