The weakening dollar has been a boon for emerging market debt in recent months. Spreads have narrowed and inflows quickly turned positive again. However, investors seem to already be looking for the exit again.
‘Our data show that a big risk-off is brewing in EM. We are tracking high frequency outflows from EM in the final weeks of September almost as big as in the 2013 taper tantrum or during 2015 RMB devaluation fears,’ said IIF economist Jonathan Fortun on Thursday.
‘The macro environment is indeed weak and growth prospects for emerging markets are unclear. We have therefore reduced our credit risk, and very recently our currency risk,’ said Witold Bahrke, macro strategist in Nordea Asset Management’s EMD team. He does not rule out further spread widening in the near future.
But in the longer term, the outlook for emerging market bonds is favourable, especially for hard currency debt, Bahrke notes. This is mainly due to the Fed’s interest rate cuts and the recent increase in dollar supply. ‘Emerging markets may not be such a clear growth story any more, but the number of investors hunting for yield has only increased with interest rates in the US now also down to zero.’
The interest rate differential between emerging and developed markets should therefore eventually prevail again for (Western) investors. ‘From a fixed-income perspective, low growth is not necessarily a problem, as long as it does not lead to too much macro-economic instability,’ says Bahrke.
Moreover, Bahrke does not expect inflation in emerging economies to become a problem, despite the pressure on many currencies (see below). ‘Inflation is also in a downward trend in emerging markets under the influence of China. There is still a lot of overcapacity in the Chinese economy, so we expect disinflationary forces to prevail for the time being›. Because of low inflation expectations, Nordea AM›s EMD funds have a relatively long duration, in combination with low credit risk.
Exchange rates under pressure
While Bahrke is reasonably positive about long-term hard currency bonds, there is less reason for optimism for local currency debt. Indeed, in many emerging markets, exchange rates have been under severe pressure since the outbreak of the coronavirus, and macroeconomic stability is worsening. For example, the exchange rates of currencies such as the Russian ruble, the Brazilian real, the South African rand and the Turkish lira have already fallen by tens of percentage points against the euro this year.
But Bahrke still sees reasons for optimism. ‹The Fed’s liquidity support to central banks in emerging markets is really a game changer. The large supply of dollars means that there is a good chance that Turkey will remain an isolated case. Mexico, for example, has recently been able to cut interest rates without any problems in order to stimulate the economy. Without the Fed’s interest rate cuts and liquidity support, that would probably not have happened›.
Commodities
With the exception of the Turkish lira (the Turkish economy was struggling even before the corona crisis and has now been hit hard by the loss of income from tourism), the troubled countries mentioned above all have in common that they largely rely on the export of commodities.
Moreover, the fund managers of all three of Nordea’s EMD funds have a strong preference for bonds from countries with a high commodity exposure.
But, according to Bahrke, this does not mean Nordea expects to see a rapid recovery in commodity prices. ‘If the price of oil remains between USD 35 and USD 45, as it is now, then that is manageable for a country like Russia that produces at relatively low cost. Our decision to keep an overweight to Russia, and also to Peru and Indonesia, is not based on the outlook for commodity prices, but mainly on the expectation of interest rate falls in these countries.
And, admittedly, Nordea AM is not the only asset manager with a strong exposure to commodities: the EMD benchmarks are dominated by exporters of oil and gas, and to a lesser extent industrial metals. Isn’t this really an existential problem for the asset class? After all, investors are now lending money to countries that are often driven by a business model that will not be viable in the foreseeable future due to the energy transition. Bahrke: ‹I expect EMD as an asset class to become less dependent on commodities and countries to diversify their economies, but it will take some time before we see that again›.
Nordea AM›s EMD funds are all in negative territory this year, with the Emerging Stars Local Bond Fund performing the worst, posting a return of -10.9%. The difference with the return of the hard currency variant of this fund is remarkable: this fund has a year-to-date return of only -2.3%, performing considerably better than the widely used hard currency benchmark: the JP Morgan GBI-EM Global Composite Index.