Focus on: Emerging market fixed income (Archivé)

As central banks continue their programme of policy normalisation, managers from Insight and Standish consider a crucial question: can EM debt continue to offer both high yields and attractive returns?

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How are external factors affecting EM debt at present?

Colm McDonagh: Our view is that central bank policy remains key. Looking forward, we think interest rate policy in developed markets is now widely understood, with investors anticipating normalisation over the medium term. That said, the context of the tightening is significant. The backdrop of an improving global growth outlook, combined with relatively benign inflation, makes developed market interest rate normalisation much more manageable for EM economies.

Robert Simpson: Commodities are also important. We think prices should be anchored by the more positive growth environment but price rises in key commodities, such as oil, are likely to be capped as higher demand will generate a rapid supply response from US shale oil production. For EMs, fluctuations are manageable as long as prices don’t reach extreme levels in either direction. If prices become too low it causes problems for commodity producers but too high can cause problems for commodity importers, such as China and India.

Federico Garcia Zamora: We’ve seen how a combination of more constructive external drivers – including stable global rates, improving commodity prices, and weakening US dollar – coupled with improving domestic fundamentals have all been supportive of the asset class. Moving into the fourth quarter of 2017 we saw how EM bonds outperformed all other sectors of the fixed income market including US investment grade and US high yield.

One of the main threats in 2018 is the continuation of the rate normalisation process in the developing world, particularly in the US, and especially if central banks reduce accommodation at a more rapid pace than markets expect. Still, our current view is this process will be very gradual and hence constructive for EM debt as an asset class.

Is EM debt still reliant on demand from China?

Colm McDonagh: China is now important globally, rather than just for emerging markets, given the size of its economy. One of the themes we’ve seen develop is that of a more regionally divided world. There are now three distinct powers: the US, the euro area and China, all of which dominate their region in terms of trade and policy. So, for Asian markets, China is very important for demand, whereas for Eastern European markets, for example, they would be more insulated, as their economies are largely linked to demand from the euro area.

Federico Garcia Zamora: We see the link between EM debt as an asset class and China as being mostly indirect via commodities. Growth in China affects commodity prices which in turn has a huge impact on the external accounts and fiscal accounts in many of the countries that are part of the universe.

Robert Simpson: We think currency risk plays a role too. If the Chinese authorities were to allow a period of unexpected currency weakness then that could be disruptive for emerging market currencies globally. The various policies put in place to stem capital outflows appear to be working, though, so China now seems to be more firmly in control again.

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Has there been a fundamental change in the way EM fixed income markets operate and how do you envision that playing out in the coming year?

Colm McDonagh: One major change in recent years is how policy makers in many emerging markets have become comfortable with using currency as a buffer to insulate their economies from negative shocks. One of the first lines of defence on any political, economic or external shock is to allow currency weakness, with authorities only stepping in to counter falls once they become significant enough for inflation pass-through to become a concern. As such, management of currency risk in order to control volatility and avoid potential losses has become even more important.

Robert Simpson: A big change we’ve seen is how much the corporate bond market has deepened. There’s now close to US$2 trillion in outstanding hard currency EM corporate debt, as the market has evolved in line with aggregate EM growth. As the global growth outlook improves we think more investors will consider increasing allocations to what is now a very significant asset class in its own right.

Where do you see the likely major opportunities and challenges for emerging market fixed income class in 2018?

Federico Garcia Zamora: Even though EM debt has had a good run in recent months we still believe there’s more to come. We believe the combination of constructive external drivers and improving fundamentals should continue to support the asset class over the next couple of years. In this context, a rebound in growth, lower to stable domestic inflation and smaller current account deficits in many of the countries that are part of our universe, can all be considered positive.

Colm McDonagh: Our view is that the outlook for the global economy has improved, with a broad-based pick-up in growth and this is generally supportive for EM assets. With this in mind we believe the next few years could be a major opportunity those EMs that are more leveraged to the global economic cycle via exports or commodity prices. Despite this improvement in the fundamental outlook, global investors remain underweight emerging markets, especially in corporates and any price weakness tends to get met with buying demand.

Robert Simpson: We’d highlight corporate bonds as an area of potential opportunity. Lower coverage means there are market inefficiencies, which in turn creates an opportunity to discover undervalued issues or misunderstood issuers which can then be used to generate alpha.

In terms of challenges, political risk is ever present. Yet this is a global rather an emerging market phenomenon, since some of the current risks are coming from the developed rather than the emerging world. The other challenge could come from stronger-than-expected global growth, since this could then lead to complacency from EM policy makers. If debt and current account imbalances start to build up this could create future problems, as we saw in 2013’s taper tantrum episode.

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