Emerging market (EM) bond managers could be forgiven for feeling afflicted by the Chinese curse, “may you live in interesting times”.
Strong first quarter performance in the local debt market, which was at odds with wider fixed income trends at the time, has been followed by a very weak second quarter in both absolute and relative terms.
In truth, there is little evidence that the origin of the curse was actually China.
The first recorded use of the phrase appears to have been by Joseph Chamberlain, with the Chinese origin seemingly added by his son, Austen.
Appropriately then, for the majority of EM this year, performance has been driven by external factors, particularly Federal Reserve policy, slower growth in the eurozone and concerns about the trade policy agenda of the US administration.
Policy responses by EM governments, a stabilisation of the US dollar and a pick up in European data are all factors that could trigger a rebound in EM bond markets.However, the domestic fundamentals of many EM economies are in fact quite bondholder friendly. Growth is generally moderate and at-or-below potential trend rates, inflation is mostly at-or-below central bank target levels, and credit growth is moderate; supporting growth without building significant imbalances.
Recent price action has left many EM currencies that already appeared to be trading below fair value looking even cheaper, while also pricing interest rate hikes into all EM curves as the policy outlook for many is more stable.
The sell-off in EM bonds over recent months has delivered a number of country-specific opportunities. Foreign investors have sold all, and more, of the South African government bonds they bought after Cyril Ramaphosa’s leadership victory at the ANC conference, despite real progress on replacing management at key institutions, reforming the mining sector and delivering a more coherent policy on land reform.
Source: HSBC, IMF (as of May 2018)
In Mexico, data has been progressively more supportive of a rate cut, but concerns about the recent election and currency volatility means the central bank has delivered a rate hike. Meanwhile, in Brazil the bond curve is now pricing in a return of the policy rate to the highs of the prior two cycles, despite below target inflation, a lacklustre recovery and high unemployment.
Moreover, opportunities are appearing even in areas where fundamentals have been less clearly positive.
Turkey and Argentina have hit the headlines this year due to very weak currencies and, in both cases, growing current account deficits and high-and-rising inflation have been clues that the economies have been growing too quickly.
We have liked Argentina for some time due to the government’s commitment to fiscal reform and our expectation that monetary policy would be kept sufficiently tight, but in the event the former has been too gradual and the commitment to the latter was questioned when rates were cut in January.
Argentina has now agreed an IMF programme that involves faster rebalancing of the fiscal account, while interest rates have been raised to 40 per cent.
Although some overshoot is not impossible, we think the Argentinian peso is a little cheap-to-fair value, even assuming higher- than-expected inflation for the remainder of this year. Investors can monetise these high interest rates through bonds linked directly to the policy rate.
Turkish authorities took a little longer to react to recent adverse market dynamics but the steps taken since have been decisive.
Crucially, we think that the rise in policy rates to 17.75 per cent will have quite a big impact on growth given how credit intensive the economy has become. Slower growth should bring both the current account deficit and inflation to more manageable levels and, ultimately, has the chance to deliver some compelling returns to bondholders.
Politicians in Turkey have traditionally preferred lower interest rates so it will pay to be vigilant to the re-emergence of political pressure on the central bank but, as with Argentina, investors are being handsomely compensated for this risk.
High yields, adjusted for inflation, in EM compared to their developed market peers offer investors very attractive compensation for the risks to the current outlook, such as deterioration in global trade policy and policy tightening by developed market central banks. Meanwhile, systemic risks are quite low compared with recent years.
Policy responses by EM governments, a stabilisation of the US dollar and a pick up in European data are all factors that could trigger a rebound in EM bond markets.
Kieran Curtis is investment director at Aberdeen Standard Investments
