Are local emerging market bonds approaching a turning point?
With slowing growth affording scope for more moderate policy tightening, emerging market local currency bonds are starting to look like good value.
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Emerging market (EM) central banks have been hiking interest rates in response to rising inflation. This is not great news for bonds, and with inflation remaining sticky, further hikes are likely needed.
As growth momentum starts to ease off, however, this will allow for more moderate policy tightening. Added to this, the average yield of local currency EM debt has risen nearly 100 basis points (bps) so far this year.
We think EM bond markets are close to an inflection point, where the likelihood of diminished rate hikes meet attractive yields. At the same time, individual country risks vary and remain key.
Russia leads the way
Russia recently surprised markets with a lower than expected interest rate hike of 25bps, to 6.75%, against expectations of 50bps. While the rhetoric accompanying the move was hawkish, it represented a rare case where the market showed no sign of discomfort with a less aggressive EM central bank policy trajectory.
Russia's early response to inflation, the central bank has tightened its key policy rate by 250bps since February, and a deep well of credibility, worked to its advantage. Though inflation remains well above the 4% target, at around 7%, it is clear the market believes the foreseeable trajectory will bend favourably. With the 10-year yield approaching 7%, this is starting to present decent value.
Focus on country specific factors
Mexico may join Russia as the next country to begin hiking rates less aggressively, having surprised the market with a 25bps hike in June, followed by another 25bps in August. The market expectation for 100bps of additional hikes is probably too high.
Hiking cycles in Peru and Chile will likely exceed that, however, and Colombia’s central bank seems particularly behind the curve as well. Brazil has been aggressive with hikes, but higher inflation recently suggests the central bank should probably have been even more so, given the low starting point of 2% nominal rates. These countries would benefit the most from exogenous factors, such as easing food and inflation pressure, that become tailwinds.
In Asia, where slower economic growth is already occurring, rates will stay low but stable and still attractive relative to developed markets.
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