Despite heightened geopolitical uncertainty and a 50bp increase in the US fed funds rate this year, yields of emerging market bonds in local currency have declined by 80bp and outperformed the benchmark 10-year US Treasury bond by 60bp.
In fact, the index yield (JPMorgan Government Bond Index-Emerging Markets (GBI-EM)) is currently at its lowest since the ‘taper tantrum’ of 2013.
Several factors have contributed to the outperformance by emerging market bonds
1. Favourable index composition
The key theme in emerging market bonds in local currency this year has been dispersion. Currently, a story of two different emerging markets (EMs) is unfolding: disinflation in high-yielding countries coexists with rising or bottoming inflation in low-yielding countries. Disinflation has allowed EM central banks to cut interest rates from very high levels.
The countries undergoing disinflation account for just over 50% of the GBI-EM index, while countries where policy rates have risen account for 22%. So in the index, the high-yielding rate cutters dominate. In addition, policy rate increases in Mexico, Argentina and Turkey (with a combined 18.7% weight) were perceived in the financial markets as having increased central bank credibility, resulting in a rally in the medium to longer-term segments of the local yield curves for most of the year.
Regionally, the decline in yields has been driven by Latin America and emerging Europe (see Exhibit 1).
Exhibit 1: Breakdown by country of the JP Morgan Government Bond Index-Emerging Markets (GBI-EM) and interest-rate regimes (falling interest rate countries in green, rising interest rate countries in red)
Source: JPMorgan, BNP Paribas Asset Management, as of 12/10/2017
2. Supportive global factors for emerging market bonds
The global macroeconomic environment has been supportive of EM bonds. Expectations for global economic growth have been revised up during the year (although the most recent revisions were downward) and leading indicators point to continued strong momentum.
Meanwhile, inflation has surprised to the downside. In addition, trade volumes and prices have risen this year, which, historically, have a multiplier effect on EM growth and a positive impact on their currencies through the terms of trade.
Additionally, rich valuations in other asset classes have attracted flows into emerging market bonds. According to JPMorgan, cumulative inflows into the asset class totalled USD 77.1 billion by September and were forecast to exceed USD 110 billion by the end of the year. That level would surpass the record of USD 103 billion in 2012. Flows have been driven by both traditional EM debt investors as well as crossover investors (see Exhibit 2).
Exhibit 2: Changes in the risk premia of emerging market bonds and selected high-yield debt indices 31/08/2012 through 23/10/2017
Source: Bank of America Merrill Lynch, JPMorgan, Barclays, BNP Paribas Asset Management, as of 23/10/2017
Unlike 2017, we foresee a less clear-cut macroeconomic theme for 2018. Alpha generation and country-level dispersion will likely prove much stronger themes. Most of the EM countries cutting interest rates are at the tail end of their monetary cycles, but further policy easing is still expected in Russia, Brazil and, potentially, Colombia. South Africa has only just begun cutting rates.
Mexico and Turkey are the only countries which will likely have sharply declining inflation next year, but the extent of monetary easing there can be expected to depend on geopolitics and inflation
In addition, some countries could be raising policy rates next year such as the Czech Republic and Romania, but these are small index components and monetary policy tightening there is already expected.
In our view, the bottom-line is that the strong tailwinds that drove EM yields markedly lower this year are likely to be less pronounced in the near term, although on the whole, yields can continue to grind lower. We expect EM yields to become more sensitive to idiosyncratic factors. Investors are also more likely to maximise interest income if capital appreciation opportunities are no longer as obvious.
The growth environment should remain supportive, with Latin America forecast to see the largest year-on-year increase in GDP growth in 2018. The EM inflation outlook is also benign with inflation remaining within the target range for most countries at the end of next year. This may look like a continuation of the environment we saw in 2017, but there are two key differences that investors should take into account in 2018.
1. The efforts by the G4 central bank to shrink their balance sheets, which can be expected to take effect towards the middle of the year. Historical data suggests that much of the flows in and out of emerging market bonds can be explained by global liquidity conditions in general and central bank balance sheet changes in particular.
2. Global inflation, and particularly US inflation. This has been a key pillar of the benign environment despite the various interest-rate rises by the US Federal Reserve. Any sign that a strong US labour market and increased wage growth are spilling over into higher underlying inflation would lead to a reassessment of the framework that markets have become accustomed to over the past several years.