Emerging market bonds fall victim to fickle sentiment

While some see emerging market bonds as a hard-hitting game in the often pessimistic world of fixed income investing, others see the field too reliant on fickle sentiment.

At the turn of this year, the asset class was back in vogue just months after the low in Q2 2020 – when exits broke records amid the onset of the global coronavirus pandemic.

Investors have come back in droves. As hopes for a rapid vaccine rollout were growing, Joe Biden’s presidential victory was seen as positive for globalization and cross-border trade. Meanwhile, extraordinarily loose monetary policy in the developed world meant “there was a crowding out effect in emerging markets,” says Jonathan Fortun, an economist at the Institute of International Finance, an industry association.

Emerging market governments have rushed to take advantage of this ideal situation, with a wave of bond issuances causing even higher inflows. But, as so often in the upside down world of developing countries, the good times could not last.

Londoner receiving Covid vaccine in August © Henry Nicholls / Reuters

“It’s been a much more difficult backdrop for emerging markets in 2021 than I think a lot of people expected,” said Paul Greer, portfolio manager, emerging markets debt at Fidelity International. “Over the past nine months, for a variety of reasons, he felt the market had eroded the optimistic positive note he had on Christmas.”

Since the start of the year, emerging market government bonds in hard currencies have generated only a total return of 0.3%. Worse yet, investors in local currency sovereign debt lost 4.8% as their currencies weakened against the dollar, with the bright spot being the 2.2% yield on corporate bonds denominated in “foreign currencies”. strong ”such as the dollar and the euro.

Column chart of monthly non-resident fixed income portfolio flows to emerging markets (in billions of dollars) showing inflows dry up as sentiment deteriorates

Greer points to the unexpected US Democrats’ control over both houses of Congress, opening the door to unprecedented levels of fiscal stimulus under President Biden, higher interest rates and a stronger dollar.

“Since the race for the Senate of Georgia [giving the Democrats control], Treasury yields started to rise, ”says Greer. “Since then, we have reduced the risks. We’re a lot less optimistic about EM now.

Georgia Democratic Senate candidates Jon Ossoff and Raphael Warnock greet each other on stage last December
Georgia Democratic Senate candidates Jon Ossoff and Raphael Warnock greet each other on stage last December © Getty Images

Gregory Smith, Emerging Markets Fund Manager at M&G Investments, also notes: “We saw a slightly more hawkish tone from the Fed as the US economy recovered; that hits emerging markets when the US 10-year yield rises.

Other factors accentuated the gloom. Smith points out that the Delta variant of the coronavirus makes the pandemic “more voracious” in countries like India and Indonesia, while “those who apply a” zero Covid “approach like China have really struggled to prevent the virus to spread “.

“Growth matters,” says Fortun. “We are counting on lower growth [in EMs] because of Delta and, also, because of weak domestic demand due to lack of fiscal space [room in the government budget for spending] many countries are going to have in the future more lack of vaccines ”.

“EM have a higher growth than DM [developed markets] – that’s why many people invest in the asset class, ”adds Greer. “But it feels like we’ve now passed through the peak of global growth.”

Greer argues that Beijing “prioritizes growth. . . the pendulum swinging towards the management of financial conditions and budgetary prudence ”as well as the fight against inequalities.

Greer argues that China is also a “growth engine” for many other emerging markets through its demand for their commodities. Lower growth in China could lead to weaker currencies in developing countries, he fears.

Shanghai buyers: economists fear Chinese economic slowdown will weaken other emerging markets
Shanghai buyers: Economists fear a slowdown in China’s economy will weaken other emerging markets © Qilai Shen / Bloomberg

Investors are taking note. Cross-border flows to non-Chinese emerging market debt turned negative for the first time in a year in August, according to the IIR. While China was still attracting money at the time, weekly flows to Chinese stocks turned negative in mid-September, potentially presaging weaker demand for fixed income securities as well.

China has benefited from an influx triggered by the country’s inclusion in major global bond and stock indices, but Fortun believes those purchases are now “largely complete.” He expects the third quarter “to be stable in terms of capital flows to [emerging markets]”.

Greer spies on other reasons link watchers in this category hide behind their couches. As global growth falters, fear of inflation emerges, which could translate into tighter monetary policies and a “headwind” for riskier assets.

On the bright side, Greer notes that yields are “substantially higher” than in developed markets, a significant factor in “an income-hungry world”, while some pockets of the sector such as Russia, Zambia and Ecuador “Got away with it dramatically. This year”.

“We get paid for some of the risks, but not all of them,” he says.

Back to work: Ecuador has vaccinated the vast majority of people in the Galapagos Islands in a bid to revive the destination's tourism industry, which generates $ 350 million a year.
Back to work: Ecuador has vaccinated the vast majority of people in the Galapagos Islands in a bid to revive the destination’s tourism industry, which brings in $ 350 million a year © Diaz Arcos / Bloomberg

Smith points to the “fortress reserves” that many Asian countries have accumulated since the financial crises of the 1990s, augmented by their share of the $ 650 billion in special drawing rights distributed by the IMF in August.

In addition, emerging countries are borrowing more and more in their own currencies, thus reducing currency risk, and current accounts are in better shape today than during the infamous “taper tantrum” of 2013 which led to a massive sale of the asset class at the time.

Fortun, however, admits that 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 proven that you can have tax room without [appearing to have] fiscal space, but we don’t know if the same track record will exist for emerging markets, ”he adds.

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