Why Emerging Market Bonds Continue to Rally
The overwhelming influence of G-3 (U.S., Japan, and Europe) monetary policy has been the dominant theme in emerging markets debt this year, and September was no exception. U.S. interest rate volatility leading up to the Federal Reserve (the “Fed”) meeting impacted hard currency bonds, while local currency sovereign bonds were boosted by stronger currencies and lower local interest rates. Overall, accommodative policies and contained inflation continue to provide support, and all sectors of emerging markets debt produced positive returns in September.
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Market Realist – Tables have turned for emerging market bonds in 2016
Emerging market (or EM) debt (EMLC)(HYEM) has, over the last several years, struggled as an asset class. Emerging markets suffered from lower commodity prices and a stronger dollar, which forced assets out of some emerging markets. This change was followed by ballooning current account deficits in some countries, forcing them to resort to financial intervention, which meant weaker currencies and perceived weaker fundamentals.
Interestingly, coming into 2016, what had been headwinds became tailwinds. Investors flocked to emerging markets from developed markets due to continued low interest rates in the United States, a rebound in commodity prices, a restrained US dollar, and expectations of more emerging market economic growth versus developed economies.
The graph above compares the annual change in the balance between supply and demand for emerging market bonds. Negative values imply a bond shortage relative to demand. Strong investor interest in emerging market debt reflected in the inflows the asset class experienced this year—after three years of outflows that began with the 2013 taper tantrum. The situation worsened due to a slump in commodity prices caused by stumbling growth expectations in China (PEK). The slump caused outflows from most emerging markets, leading to the drastic weakening of their currencies.
But, coming to 2016, just like 2009, we see that bond supply is scarce. Issuance is above last year’s very low levels but enough to meet a wall of demand, according to Dealogic data. Led by central bank bond-buying globally and long-term investors—including pension funds and insurers—worldwide demand for bonds is expected to rebound 46% by the end of this year, according to J.P. Morgan.
Market Realist – Emerging markets were the most sought-after in the third quarter
As the chart above shows, emerging markets have attracted a lot of attention from investors as a better and higher-yielding alternative. The demand for EM debt rose especially in June, after fears of an interest rate hike largely subsidized. Investors generally favor hard-currency emerging market bonds, though local-currency bonds are also in demand lately. This trend reflects in the MSCI Emerging Markets Index, which returned ~ 17% year-to-date (or YTD) whereas the MSCI EAFE Index and the S&P 500 returned -0.62% and 2.64%, respectively, as of November 2.
The World Bank has downgraded its global growth forecast for 2016 to 2.4% from the 2.9% projected in January. The move is due to sluggish growth in advanced economies, low commodity prices, weak global trade, and declining capital flows.
While global growth statistics remain within muted expectations, emerging market debt and equity could remain the beneficiaries of additional capital flows for some time. The inflows to emerging market debt funds to date in 2016 are quite small relative to emerging market debt funds in 2015. In the next part of this series, we’ll examine how interest rate volatility has boosted emerging market bonds.