(from my colleagues Dr. Win Thin and Ilan Solot)
In the current state of gradual and uneven recovery of EM assets, we favour a rotation from foreign to local currency fixed income instruments in many emerging markets, especially in countries where the interest rate cycles is peaking. Here are a five reasons why:
(1) The risk in US treasury yields is now tilted to the upside. Even with the first hike by the Fed more than a year away, it is hard to imagine reasons that will drive US yields much lower from here, and especially breach the 2.5% resistance level. It seems more likely to us that yields will gradually drift higher from here, especially after the sharp pullback from 3.0% earlier this year that caught most market participants on the back foot. But the key word here is “gradual.” A sharp and material rise in US yield would surely bring about another wave of sell-offs in EM, and local rates will be no exception. However, that is not our base case. In any case, shorter duration in USD dollar debt seems advisable going forward.
(2) Local rates are probably close to peaking in many countries and yields are far more attractive. This is especially the case in the higher yielding ones, such as Brazil, India, Indonesia, and Turkey. Any additional tightening is likely to be residual. Moreover, inflation is likely to start gradually moving lower, which should help local curves to flatten. Using Bloomberg generics as reference, 5-year yields rose about 340 bp in Brazil, 270 bp in Indonesia, 235 bp in South Africa, 132 bp in India and 94 bp in Mexico, from May 2013 until now. Others that may do well in 2014 are Colombia (10-year government bond yield near 6.40%), Mexico (6.25%), Peru (5.92%). And the move higher in sovereign yields has likely opened up several new opportunities in the corporate space as well. Those that offer high yield but higher risks include Russia (10-year 9.41%) and Hungary (5.40%), and we would avoid them for now.
(3) FX risk for EM is much smaller. The sharp losses in EM currencies were one of the main reasons behind the exodus by global investors from local debt markets. This risk is now vastly diminished, and in some cases, tilted towards further gains. Although many EM currencies have already rallied over the last month or so, most are still far from the levels seen in mid-2013. Moreover, the reaction function by EM policymakers is far more geared towards defending local currencies from further depreciation, many of which (Brazil and India, for example) now offer reasonably credible backstops. On the other hand, we continue to be wary of taking on FX risk in the more fundamentally weak countries such as Turkey and South Africa, especially for the medium-term view in this report.
(4) Positioning is much lighter. This is admittedly difficult to quantify, but anecdotal evidence we have pieced together suggests investors have indeed pulled out a lot of money from local markets, and that in some cases money is already starting to return.
(5) DM bonds have gotten too rich. Just as we saw a rotation from EM into distressed DM over the course of 2013, we are likely to see a rebalancing of this at some point. The euro zone peripheral bonds have rallied so much over the past year that yields are no longer attractive compared to EM, which in turn have cheapened. We believe, when given the choice, a USD-based investor may soon prefer to hold a Brazilian government bond yielding 12.55% in the 10-year space over Portugal (3.70%), Italy (3.12%), and Spain (3.06%) – at least while as the government continues to support the BRL.
In the current state of gradual and uneven recovery of EM assets, we favour a rotation from foreign to local currency fixed income instruments in many emerging markets, especially in countries where the interest rate cycles is peaking. Here are a five reasons why:
(1) The risk in US treasury yields is now tilted to the upside. Even with the first hike by the Fed more than a year away, it is hard to imagine reasons that will drive US yields much lower from here, and especially breach the 2.5% resistance level. It seems more likely to us that yields will gradually drift higher from here, especially after the sharp pullback from 3.0% earlier this year that caught most market participants on the back foot. But the key word here is “gradual.” A sharp and material rise in US yield would surely bring about another wave of sell-offs in EM, and local rates will be no exception. However, that is not our base case. In any case, shorter duration in USD dollar debt seems advisable going forward.
(2) Local rates are probably close to peaking in many countries and yields are far more attractive. This is especially the case in the higher yielding ones, such as Brazil, India, Indonesia, and Turkey. Any additional tightening is likely to be residual. Moreover, inflation is likely to start gradually moving lower, which should help local curves to flatten. Using Bloomberg generics as reference, 5-year yields rose about 340 bp in Brazil, 270 bp in Indonesia, 235 bp in South Africa, 132 bp in India and 94 bp in Mexico, from May 2013 until now. Others that may do well in 2014 are Colombia (10-year government bond yield near 6.40%), Mexico (6.25%), Peru (5.92%). And the move higher in sovereign yields has likely opened up several new opportunities in the corporate space as well. Those that offer high yield but higher risks include Russia (10-year 9.41%) and Hungary (5.40%), and we would avoid them for now.
(3) FX risk for EM is much smaller. The sharp losses in EM currencies were one of the main reasons behind the exodus by global investors from local debt markets. This risk is now vastly diminished, and in some cases, tilted towards further gains. Although many EM currencies have already rallied over the last month or so, most are still far from the levels seen in mid-2013. Moreover, the reaction function by EM policymakers is far more geared towards defending local currencies from further depreciation, many of which (Brazil and India, for example) now offer reasonably credible backstops. On the other hand, we continue to be wary of taking on FX risk in the more fundamentally weak countries such as Turkey and South Africa, especially for the medium-term view in this report.
(4) Positioning is much lighter. This is admittedly difficult to quantify, but anecdotal evidence we have pieced together suggests investors have indeed pulled out a lot of money from local markets, and that in some cases money is already starting to return.
(5) DM bonds have gotten too rich. Just as we saw a rotation from EM into distressed DM over the course of 2013, we are likely to see a rebalancing of this at some point. The euro zone peripheral bonds have rallied so much over the past year that yields are no longer attractive compared to EM, which in turn have cheapened. We believe, when given the choice, a USD-based investor may soon prefer to hold a Brazilian government bond yielding 12.55% in the 10-year space over Portugal (3.70%), Italy (3.12%), and Spain (3.06%) – at least while as the government continues to support the BRL.
Local vs Foreign Emerging Market Debt
Reviewed by Marc Chandler
on
April 29, 2014
Rating:
Reviewed by Marc Chandler
on
April 29, 2014
Rating:
