Are EM bonds and currencies poised for a come back?
After a tough 2021, emerging market debt now offers good value, and is well placed to withstand the macroeconomic challenges ahead.
The triumvirate of tightening global liquidity, peaking growth expectations and unrelenting inflationary pressures make it a challenging outlook for many asset classes.
However, this difficult backdrop is starting to have less of a negative impact on many emerging market (EM) bonds and currencies. These have shown some resilience so far this year in the face of rising developed market bond yields and weaker global equity markets.
The key question is whether this apparent resilience could be an early sign that the recent severe underperformance of EM assets has now run its course.
We think EM debt is now offering good value, especially in the local currency bond markets, currencies themselves and pockets of the hard currency (US dollar-denominated) debt market. Importantly, EM is now broadly in a good position to weather challenging global liquidity and inflation conditions.
Has EM already absorbed liquidity pressure?
The reduction in global financial liquidity poses a significant challenge to risk assets.
Global real money growth started slowing last year, according to our internal measure, from 10% in November 2020 to 3.6% as at the end of 2021.
This could now be exacerbated by a more aggressive withdrawal of liquidity by developed market central banks as their tightening cycles are only just starting.
However, this rapid deterioration in global liquidity has already been absorbed to a large extent by EM fixed income assets given their sharp re-pricing last year. There is also a possibility we could see some stabilisation in global money supply. China has recently started to ease and we have seen a reacceleration in commercial bank lending globally.
Is growth slowdown just a temporary pause?
A second challenge facing EM assets is the slowdown in global growth expectations, with the recent upturn in the global growth cycle potentially having already peaked (see chart). Despite this loss in global growth momentum, we are not overly worried about the outlook for global economic activity. The recent weakness looks more like a temporary pause due to the Omicron wave and to the disruptions to the global supply chains.
A rebounding global credit impulse, strong labour markets and pent-up demand accumulated during the pandemic should continue to support growth. A number of EM countries, where the pandemic hampered the growth rebound last year, are particularly due for a catch-up. There are clearly growing expectations that the underperformance of EM growth versus the US will end.
Is inflation yet to peak?
A more significant source of pressures for EM assets over the course of the last 12 months has been the broad-based surge in inflation. Much commentary around the issue has focused on the likely transitory nature of inflation, but we are yet to see a convincing peak in the global inflation cycle.
The continued strength in commodity prices could sustain inflationary pressures in the foreseeable future.
Despite this, a number of long-dated EM local bond markets are well positioned to withstand these pressures. This is particularly the case in a number of key EM countries where central banks have already made good progress in normalising their monetary policies and government yields are starting to offer value.
Pockets of value in EM high yield
In the hard currency (that is, US dollar) segment, we see appealing pockets of value in the high yield sub-sector, where the average spread has widened to an attractive 645bps (Source: JP Morgan EMBI Global Diversified HY index). Our long-term valuation score of EM dollar debt high yield highlights that this sub-sector has become recently attractive, as shown in the chart.
Our conviction is tempered by our concerns about the poor liquidity in the sector, with signs that inflows into EM dollar debt are running out of steam.
Local currency debt at attractive levels
While developed world central banks have been behind the curve in their policy responses to surging inflation, a number of EM central banks have already acted decisively. The tightening cycle is already well-advanced in countries such as Russia, Brazil and Mexico and we are even starting to see some tentative evidence of inflation peaking in these countries.
Even central banks in Czech Republic, Hungary and Poland have moved away from their ultra-lax monetary policies of recent years. This has led to a surge in bond yields in Central Europe, where local debt spreads versus German Bunds have surged to their highest levels since the eurozone debt crisis.
This progress in normalising monetary policy combined with attractive real bond yields has created attractive pockets of value in EM local rates. Some of the most attractive nominal and real bond yields in 2022 can be found in Brazil, Russia, Mexico, Indonesia and South Africa. We maintain core exposures to these government bond markets with a particular focus on the long end of the curves.
Value in currency
Currencies of EM commodity exporting countries should be supported by attractive real effective exchange rate valuations, stable external accounts, stronger commodity prices and improving interest rate support (attractive carry). These positive factors have not benefited EM currencies over the last 12 months as the US dollar broad strength continued, underpinned by US economic growth outperforming the rest of the world and the prospects of the Federal Reserve (Fed) normalising policy.
This period of US growth outperforming appears to be coming to an end. Monetary and fiscal stimulus is fading in the US and a number of EM economies could now see a more sustainable post pandemic expansion. With most EM central banks being well ahead of the Fed in the current tightening cycle, EM currencies could show more resilience even as the Fed hikes.
In the current global inflationary environment, currencies of commodity exporting countries should be well positioned. These currencies appear to be the most attractively valued in the EM universe, particularly in Latin America. On top of being very cheap, these currencies should also see a boost from the continued resurgence in commodity prices. As shown in the chart, the surge already seen in commodity prices has yet to be reflected in the value of most EM currencies.