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Could EM bonds and currencies be poised for a comeback? - Individual Investors - Schroders
PERSPECTIVE
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.
02/14/2022
Abdallah Guezour
Head of Emerging Market Debt and Commodities
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
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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.
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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.
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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.
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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.
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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
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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.
The views and opinions contained herein are those of Schroders’ investment
teams and/or Economics Group, and do not necessarily represent Schroder
Investment Management North America Inc.’s house views. These views are
subject to change. This information is intended to be for information purposes
only and it is not intended as promotional material in any respect.
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