While some regard emerging market bonds as punchy play in the often stolid world of fixed income investing, others see the field as all too dependent on fickle sentiment.
At the turn of this year, the asset class was back in vogue just months after the nadir of the second quarter of 2020 — when outflows broke records amid the onset of the global coronavirus pandemic.
Investors returned en masse. Hopes of a rapid rollout of vaccines were rising, Joe Biden’s presidential victory was seen as positive for globalisation and cross-border trade. Meanwhile, extraordinarily loose monetary policy in the developed world meant “there was a crowding-out effect into emerging markets”, explains Jonathan Fortun, an economist at the Institute of International Finance, an industry association.
Governments of emerging markets rushed to take advantage of this sweet spot, with a wave of bond issuance eliciting still higher inflows. But, as so often in the topsy-turvy world of developing countries, the good times could not last.
“It has been a much more challenging backdrop to EMs in 2021 than I think a lot of people expected,” says Paul Greer, portfolio manager, emerging market debt at Fidelity International. “Over the last nine months, for a variety of reasons, it has felt that the market has been chipping away at the upbeat positive note that it had at Christmas.”
So far this year, hard currency EM government bonds have eked out a total return of just 0.3 per cent. Worse still, investors in local currency sovereign debt have lost 4.8 per cent as their currencies weakened against the dollar, with the bright spot being the 2.2 per cent return in corporate bonds denominated in “hard currencies” such as dollars and euros.
Greer points the finger at the US Democrats’ unexpected control of both houses of Congress, opening the door to unprecedented levels of fiscal stimulus under President Biden, increased interest rates, and a strengthening dollar.
“Since the Georgia senate race [giving the Democrats control], Treasury yields have started to go up,” Greer points out. “Since then, we have been de-risking. We are much less optimistic on EM now.”
Gregory Smith, emerging markets fund manager at M&G Investments, also notes: “We have seen a slightly more hawkish tone from the Fed as the US economy has come back; that hits EMs when the US 10-year yield rises.”
Other factors have heightened the gloom. Smith points to the Delta variant of coronavirus rendering the pandemic “more voracious” in countries such as India and Indonesia, while “those that apply a ‘zero Covid’ approach such as China have really struggled to stop the virus from spreading”.
“Growth matters,” says Fortun. “We are pencilling in weaker growth [in EMs] because of Delta and, also, because of the weakness in internal demand due to the lack of fiscal space [room in the government budget for spending] many countries are going to have in the future, plus the lack of vaccines”.
“EMs have higher growth than DMs [developed markets] — that’s why many people invest in the asset class,” adds Greer. “But it feels like we have gone through the peak of global growth now.”
Greer argues Beijing is “deprioritising growth . . . with the pendulum swinging towards managing financial conditions and fiscal prudence” as well as tackling inequality.
Greer argues that China is also an “engine of growth” for many other emerging markets via its demand for their commodities. Weaker growth in China may lead to weaker currencies across the developing world, he fears.
Investors are taking note. Cross-border flows into non-Chinese emerging market debt turned negative for the first time in a year in August, according to the IIF. While China was still attracting money then, weekly flows into Chinese equities turned negative in mid-September, potentially presaging softer demand for fixed income as well.
China has been benefiting from inflows triggered by the country’s inclusion in the world’s major bond and equity indices, but Fortun believes such buying is now “largely completed”. He expects the third quarter “to be flat in terms of capital flows into [emerging markets]”.
Greer spies other reasons for bond watchers in this category to hide behind their sofas. While global growth stutters, fear of inflation is emerging, which could result in a tightening of monetary policies and a “headwind” for riskier assets.
On the plus side, Greer notes that yields are “substantially higher” than in developed markets, an important factor in “an income-hungry world”, while some pockets of the sector such as Russia, Zambia, Ecuador, “have done spectacularly well this year”.
“We get paid for some of the risks, but not all of them,” he says.
Smith points to the “fortress-like reserves” many Asian countries have built up since the financial crises of the 1990s, augmented by their share of the $650bn of special drawing rights doled out by the IMF in August.
Moreover, EMs are increasingly borrowing in their own currencies, reducing foreign exchange risk, and current accounts are in better shape now than during the infamous 2013 “taper tantrum” that led to a massive sell-off in the asset class at the time.
Fortun, though, admits there are “things that keep me awake at night” — including the credibility of central bank policy and a lack of fiscal space in over-indebted countries.
“Among DMs, Japan and the UK have proved that you can have fiscal space without [appearing to have] fiscal space, but we don’t know if the same assessment will exist for EMs,” he adds.