Will there be a cyclical correction or a structural shift in
emerging market (EM) allocation story this year?
Thats the question facing EM fixed-income managers after
the sell-off last week amid a rout in the Japanese stock
market, weak Chinese economic data and fears the US Federal
Reserve will unwind its extraordinary stimulus.
High-beta market currencies sold off last week, while
trading in a benchmark EM local currency bond ETF entered the
technical oversold territory, amid a strengthening dollar and
fears over the upward trajectory of US treasuries.
In recent years, investors have paid through the nose for
balance-sheet strength, triggering inflows into EM local
currency debt even as EM equities de-rated and the eurozone
sovereign debt crisis raged.
Although the EM debt asset class has been locked in a
risk-on/risk-off spasm in recent years, yield-starved and
undiversified investors in global GDP-weighted terms
charged into long-duration local currency debt markets
from 2010. This year, the trend has seemingly intensified.
According to fund-tracker EPFR, year-to-date EM local
currency funds have absorbed a net $20.85 billion versus $5.41
billion for the corresponding period last year.
has sparked fears that an
unsophisticated herd of investors have charged into local
markets. Foreign ownership of the local government debt stock
in economies as diverse as Indonesia, Mexico and Turkey,
accounts for as much as 58% of ownership in some cases.
Nevertheless, surprisingly, during global market routs
and US Treasury rallies, EM local currency debt has tended to
outperform even amid global growth concerns.
This seemed to confirm the asset classs newfound
status as a relative safe haven, for some market players.
However, this bet depended on two big variables: the weakness
of the US dollar and low US treasuries.
With 10-year US treasuries again spiking above the
psychologically important threshold of 2%, on the back of
improving growth, some analysts are now calling for the peak in
the EM local currency debt asset class.
EM as US Treasury play
Capital Economics analysts say: Emerging market local
currency government bond yields have fallen sharply in the past
few years. Our GDP-weighted overall 10-year yield of a sample
of 18 EM sovereign borrowers has dropped by 125 basis points
since the start of 2011 to around 4.4% at the end of April.
Our calculations suggest that almost the entire
decline in the yield has been due to a drop in the risk-free
rate rather than in the credit spread. And since the risk-free
rate reflects long-term expectations for monetary policy, this
suggests that the fate of EM local currency bonds will depend
large extent on how short-term rates evolve.
The analysts state that in their sample base of 18 EM
economics, the benchmark policy rate will be higher in 10
cases, the same in five and lower in only three, with rate
hikes in emerging Asia and Latin America offset only in part by
cuts in emerging Europe, vexing allocation strategies amid
anticipation of higher yields on offer next year.
The research shop concludes: Overall, though, the best
days for EM local currency bonds may now be over. For a start,
the risk-free component of our 10-year overall yield seems
unlikely to fall further over the next year and a half if we
are right to expect some small rise in policy rates on
Admittedly, there may still be some room for long-term
risk-free rates to fall in emerging Europe. But this region is
most vulnerable to a flare-up of the crisis in the eurozone,
which alongside renewed concerns about the longevity of the
Feds quantitative easing, could prompt a spike in credit
In other words, EM local currency debt is a UST play and the
outperformance of the asset class is over unless there is a big
upward re-rating of EM credit risk. If capital appreciation no
longer drives returns then that leaves ever-decreasing coupon
payments and FX returns. However, on the latter, the outlook
does not look pretty if you reckon EM currencies are set to
weaken against the dollar, given the historic contribution of
FX appreciation to overall EM local currency debt returns, as
this UBS chart lays bare:
To add to the bearish narrative, BCA Research reckon
global deflation could trigger a disorderly rout in EM credit
The recent US dollar firmness is indicative of
budding deflationary pressures in the global economy. This
bodes ill for EM equity and credit markets. Stay short a basket
of EM currencies versus the US dollar. Indonesia will likely
experience a material deterioration in its liquidity
conditions. Stay short the rupiah and continue to underweight
Poland is flirting with deflation. Continue to bet on
lower interest rates in
Poland and short the zloty against the US dollar.