Tapering could weigh on emerging market debt in 2014

The JP Morgan EMBI Global Diversified index fell by 5.25 per cent during 2013. All but one of the funds in the Morningstar global emerging market bonds sector made a loss, proving how exposed the asset class is to external factors.

Comments from Federal Reserve chairman Ben Bernanke hinting about the tapering of QE in May was one of the factors influencing their poor performance, as investors using ‘cheap’ dollars to invest in this sector piled out of emerging markets in anticipation of rising rates.

Those emerging market currencies belonging to countries with large current account deficits, such as the Indonesia rupiah and the Indian rupee, got badly hit by the tapering talk. However, could tapering still have an impact on emerging market debt in 2014?

Investec emerging market debt co-head Peter Eerdmans says that the impact of tapering could be “smaller than expected” in 2014, and adds the Fed was trying to ‘teach the market a lesson’ when it withdrew the expected taper.

Mr Eerdmans explains that while markets subsequently recovered, treasury yields are still now at roughly 2.7 per cent, which means “we are starting from a high level, and hence any sell-off should be more contained”.

However, he emphasises that the pace of withdrawal of QE will be a key driver of emerging market debt in 2014. He says: “We need to be on top of where external flows are coming from in terms of financing the deficits of certain markets in our universe such as Indonesia and Brazil.”

John Berry, who runs the Baillie Gifford Emerging Markets Bond fund, is also cautious of the fund’s exposure to those emerging market countries with large current account deficits.

As these countries would have to hike their own policy rates more than expected as a result of rising rates in the West.

He is underweight the South African rand and Turkish lira and Indonesian bonds, as these countries are particularly exposed to this risk.

However, rates in developed markets being hiked sooner than expected is not his central expectation, as “there is nothing to suggest there is strong inflationary pressure building in developed markets”.

Edwin Gutierrez, portfolio manager in the team that manages the Aberdeen Emerging Market Bond fund, has a different view on the value of Indonesian government bonds.

He increased exposure to these bonds from an underweight to neutral position in the first week of the year, as the bonds look cheap, yields have doubled to 6 per cent and the currency volatility has gone down.

He says reforms are going through, as “the government hiked interest rates and increased foreign exchange (Fx) reserves and the current account deficit has decreased”.

Mr Gutierrez’s concern is more China’s growth than tapering: “We think the market underestimates the risk there in terms of downside for growth in China, the second most important support, in terms of exports, for the asset class.

“Anything that affects growth there can weigh on sentiment in emerging markets.” As a result, he is not too exposed to countries levered to China’s growth.

Meanwhile, Whitechurch managing director Gavin Haynes warns: “We expect to see more volatility in emerging markets with tapering, especially if the recovery happens too quickly and the Fed has to tighten monetary policy sooner.”

Joanne Ellul is a freelance journalist