Will there be a cyclical correction or a structural shift in the emerging market (EM) allocation story this year? That’s the question facing EM fixed-income managers after the sell-off last week amid a rout in the Japanese stock market, weak Chinese economic data and fears the US Federal Reserve will unwind its extraordinary stimulus.
High-beta market currencies sold off last week, while trading in a benchmark EM local currency bond ETF entered the technical oversold territory, amid a strengthening dollar and fears over the upward trajectory of US treasuries.
In recent years, investors have paid through the nose for balance-sheet strength, triggering inflows into EM local currency debt even as EM equities de-rated and the eurozone sovereign debt crisis raged.
Although the EM debt asset class has been locked in a risk-on/risk-off spasm in recent years, yield-starved and undiversified investors – in global GDP-weighted terms – charged into long-duration local currency debt markets from 2010. This year, the trend has seemingly intensified. According to fund-tracker EPFR, year-to-date EM local currency funds have absorbed a net $20.85 billion versus $5.41 billion for the corresponding period last year.
This rally has sparked fears that an unsophisticated herd of investors have charged into local markets. Foreign ownership of the local government debt stock in economies as diverse as Indonesia, Mexico and Turkey, accounts for as much as 58% of ownership in some cases.
Nevertheless, surprisingly, during global market routs and US Treasury rallies, EM local currency debt has tended to outperform even amid global growth concerns.
This seemed to confirm the asset class’s newfound status as a relative safe haven, for some market players. However, this bet depended on two big variables: the weakness of the US dollar and low US treasuries.
With 10-year US treasuries again spiking above the psychologically important threshold of 2%, on the back of improving growth, some analysts are now calling for the peak in the EM local currency debt asset class.
EM as US Treasury play
Capital Economics analysts say: “Emerging market local currency government bond yields have fallen sharply in the past few years. Our GDP-weighted overall 10-year yield of a sample of 18 EM sovereign borrowers has dropped by 125 basis points since the start of 2011 to around 4.4% at the end of April.
“Our calculations suggest that almost the entire decline in the yield has been due to a drop in the risk-free rate rather than in the credit spread. And since the risk-free rate reflects long-term expectations for monetary policy, this suggests that the fate of EM local currency bonds will depend to a large extent on how short-term rates evolve.”
The analysts state that in their sample base of 18 EM economics, the benchmark policy rate will be higher in 10 cases, the same in five and lower in only three, with rate hikes in emerging Asia and Latin America offset only in part by cuts in emerging Europe, vexing allocation strategies amid anticipation of higher yields on offer next year.
The research shop concludes: “Overall, though, the best days for EM local currency bonds may now be over. For a start, the risk-free component of our 10-year overall yield seems unlikely to fall further over the next year and a half if we are right to expect some small rise in policy rates on average.
“Admittedly, there may still be some room for long-term risk-free rates to fall in emerging Europe. But this region is most vulnerable to a flare-up of the crisis in the eurozone, which alongside renewed concerns about the longevity of the Fed’s quantitative easing, could prompt a spike in credit spreads.”
In other words, EM local currency debt is a UST play and the outperformance of the asset class is over unless there is a big upward re-rating of EM credit risk. If capital appreciation no longer drives returns then that leaves ever-decreasing coupon payments and FX returns. However, on the latter, the outlook does not look pretty if you reckon EM currencies are set to weaken against the dollar, given the historic contribution of FX appreciation to overall EM local currency debt returns, as this UBS chart lays bare:
To add to the bearish narrative, BCA Research reckon global deflation could trigger a disorderly rout in EM credit this year.
“Poland is flirting with deflation. Continue to bet on lower interest rates in Poland and short the zloty against the US dollar.”
Falling global growth and lower inflation, amid lower commodity and manufacturing goods prices, a decline in the US money multiplier – even with QE – and tighter Chinese credit conditions will all serve to boost the US dollar.
BCA concludes: “Depreciating EM currencies and falling commodity prices will warrant higher sovereign and corporate spreads as US dollar denominated debt becomes more expensive to service, necessitating a re-pricing of credit risk, ie wider credit spreads, especially from current very low levels.”
In other words, the speed of portfolio inflows that boosted the asset class was, to some extent, de-linked from fundamentals, and a US dollar breakout, weakness in EM currencies and higher US Treasury yields are three big risks on the horizon for real-money EM investors.
Against this backdrop, here are some market developments we could see in the next couple of months:
- If US Treasury yields continue to spike, local currency investors will inevitable take fright. The question is: can the majority of fund mangers pay for the redemptions from their cash balances?
-Only a limited number of bond positions are FX-hedged because the EM allocation thesis is, in part, boosted by the FX appreciation story. If so, a continuing USD rally would imperil the performance of EM local currency bond funds. In turn, the decline in NAVs of bond funds could trigger additional bond redemptions and wider asset price sell-offs.
- In illiquid markets, the wildly divergent bid/offer spreads from market-makers could imperil price discovery and create bottlenecks for investors seeking to exit. Remember 2008?
For those investors that see EM growth as a high-beta play on the developed world, then all these bearish market moves would be justified on the basis of fundamentals, of course. For others, the short EM local currency debt call is risky as the jury is out on the strong dollar call, the yields on offer in EM are still decent relative to monumental financial repression in West and the Fed has proved it can manipulate UST downwards whenever it so decrees.