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outlook for emerging market bonds

April 2019

Emerging markets' sunny prospects

EM economies are already outpacing their developed counterparts. And they'll benefit most from a rebound.

Forget the recent market upheavals, emerging market (EM) bonds are in something of a sweet spot. Indeed, the coming year could well prove to be the reverse of a rather grim 2018.

That positive appraisal boils down to two factors. First, although the global economy has been slowing, emerging economies are doing relatively better than their developed counterparts. Second, policies are being put into place around the world to re-ignite growth. Historically, EM assets tend to outperform in both of these economic environments.

Lex forex

The world leading indicator, which does a good job of anticipating what’s likely to happen to global growth, has been on a sharp downward trend since its 2017 peak. But while the outlook for emerging markets has also weakened, the bulk of the global slowdown is accounted for by developed economies.

The US Federal Reserve’s series of rate hikes through to last December, US President Donald Trump’s belligerence over trade, shifts in global demand for cars, as well as more localised problems like Italy’s and the UK’s fractious politics caused developed economies to shift into lower gear.

By contrast, the bulk of the EM slowdown has been concentrated in Turkey and Argentina – countries that have suffered self-inflicted economic injuries.

As a result, EM economies’ growth premium over their developed counterparts has opened up considerably over the past year to where the gap is now at its widest since 2013. (See chart)

open wide

Differential between EM and DM leading indices (y-o-y % change) vs. USD/EM exchange rate* (01.01.08 = 100)

Differential between EM and DM leading indices

Basket of 31 EM currencies versus the dollar. Source: Pictet Asset Management, CEIC, Datastream, Bloomberg. Data from 01.01.2011 to  01.01.2019

That’s important because in those periods when the global economy has been slowing unevenly but developing economies have outperformed, EM currencies have appreciated against the dollar – at a rate of 1.7 per cent a year on average, according to our analysis.

That trend is even more pronounced for EM currencies of larger developing nations such as China, India, Korea, Russia and Brazil among others. On average, these currencies have gained an annual 4.7 per cent against the dollar, with Latin American and East European currencies tending to do best.

EM currencies could also benefit from US developments.

The Fed has pulled the emergency brake on its tightening policy. Not only has the central bank stopped hiking rates – there’s a growing expectation that its next move will be to cut – but it is prematurely ending the reduction of its balance sheet. This dovish turn should kick-start US growth later this year. But for now, it could signal an end to the dollar’s unrelenting strength.

As it stands, EM currencies are at close to their most undervalued against the dollar for at least the past two decades. Together these factors should help boost EM currencies and, therefore, EM sovereign bonds priced in local currencies – a substantial proportion of the return on this debt tends to be driven by foreign exchange movements.

Ready for a rebound

It’s not just the Fed that’s started to started to respond to the global slowdown. The European Central Bank is resuming its targeted longer-term refinancing operations for banks in an effort to shore up the flat-lining euro zone economy.

But once again, China is the major source of aggressive policy stimulus. The People’s Bank of China has chopped back banks’ reserve requirement ratios five times during the past year in an effort to reignite lending, with further cuts expected over the coming months. At the same time, the Chinese government has sharply expanded infrastructure investment, having cut it back during 2018.

Fundamentally attractive

More generally, EM bonds should be supported by improved local conditions. Prudent macro-economic policies and, in particular, EM central banks’ relative hawkishness suggest EM economies should be less volatile than in the past.

Meanwhile, global trade tensions are perhaps less of a cause for alarm than they might once have been. As EM economies have become richer, they’ve also become less dependent on exports, with domestic demand picking up some of the slack. And as countries like China have become increasingly developed, they’ve also taken on higher value-added manufacturing, with the effect of domesticating ever more of the supply chains that had hitherto been spread across a number of countries.

Once again, China is the major source of aggressive policy stimulus.

There’s also considerable potential for investment across the emerging universe to rebound with a lessening of trade tensions.

Among EM countries, we find Brazil particularly attractive. There, the new government’s reform agenda has helped to turn the focus back onto the country’s positive fundamentals. Indeed, we like Latin America generally.

By contrast, economies with big imbalances – not least Turkey and Argentina – are likely to remain vulnerable to sharp reversals.

All of which suggests that after the turmoil of 2018, most EM countries should benefit from their relative strength, together with realistic prospects for a broad-based rebound later this year.