Frontier Markets  

Cautious optimism over bond prospects

This article is part of
The Guide: Investing in Frontier Markets

Cautious optimism over bond prospects
Developments in European politics could continue to pose risks to frontier markets

Global indicators, by and large, continue to point towards a modest acceleration of global economic dynamics in 2017.

The improvement has been relatively broad based, with the US continuing to lead the way, notwithstanding slightly mixed data of late. 

While the continued, gradual improvement in economic activity in the country increases the risks of additional monetary tightening, overall yield levels are likely to be anchored by persistently and substantially lower yields in other major developed markets, such as the eurozone and Japan. 

The prospects of fiscal spending under the new Trump administration in the US may face obstacles in Congress and are likely to be diluted to reduce the impact. 

Despite a recent uptick, inflation should stay benign in most of the developed world, especially in the eurozone and Japan. The combined picture of improving growth amid a benign inflationary backdrop should not be disruptive for fixed income in the near term. 

Importantly, economic growth in emerging and frontier market economies has stabilised amid relatively high real interest rates, undervalued currencies and stable-to-improving commodity prices. This positive combination of factors should offer the broader emerging market debt (EMD) asset class a better balance against any potential headwinds.

Valuations, despite tightening, are not far from fair. The frontier market debt index spread was roughly 444 basis points (bps) compared with 310 bps for EMD hard currency at the end of March 2017. 

The asset class is probably fairly valued from its own historical perspective, considering improving emerging and frontier market fundamentals. But versus other comparable fixed income asset classes, the valuation is still relatively attractive.

Besides, the emerging and frontier market growth differential with developed markets is forecast to increase. In theory, spreads could still compress a bit further from here. 

The net issuance in EMD is expected to be seasonally low in the short term since April redemptions are large. Against this backdrop, the sustained inflows into the asset class so far this year will continue to offer solid support. 

The spread in the JPM Nexgem index, which tracks frontier market debt, widened in March by 17 bps. The US Treasury yield curve shifted upwards slightly, with two-year, five-year and 10-year maturities moving up by about 4 bps. This detracted a little from the index’s total return, yet given the relatively high carry it posted a small positive return.

Oil prices were relatively stable, albeit slightly lower, with Brent crude ending the month at $52.8 a barrel. The US Federal Reserve’s rate hike of 25 bps was expected by most market participants, and the risk sentiment also benefited from the Dutch election result, where the eurosceptic far-right Freedom Party performed worse than expected.

The inflows into the broader EMD asset class gathered further momentum in March, at $11bn (£8.5bn), which almost doubled the year-to-date inflows to an overall $22.9bn.