investment viewpoints
The rotation continues with EM local-currency bonds
In the latest instalment of Simply Put, where we make macro calls with a multi-asset perspective, we consider whether the recent outperformance of emerging local-currency bonds over their hard-currency peers should continue.
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The rotation turns to EMs
Since the first two weeks of January, the rotation to value has intensified into a bloodbath concentrated on growth assets, technology firms and US stocks. Yet during this uncertainty, there is more than meets the eye. We think it is essential to spend time pinpointing peculiarities in the current situation – and emerging-market (EM) bonds serve as an example. In the context of the current rotation, EM assets have held their ground quite well, with local-currency bonds standing out. What is the reason for this, and will it continue?
EM local-currency bonds are generally considered to be a more volatile and risky asset than EM hard-currency debt. The former are issued by EM countries in their own currency and are therefore exposed to local currency and rates risk; the latter are predominantly issued in US dollars and tend to exhibit lower currency risk and are exposed to US rate risk. Local-currency bonds usually underperform their hard-currency peers during risk-off episodes. In 2021, EM local-currency bonds lost around 9% of their value1 while hard-currency bonds only declined by 2%2: a sign of their higher level of risk.
Rapidly rising EM yields explained most of that performance spread. Yet recently, the opposite has happened. Year-to-date, EM local-currency bonds delivered -0.1% in performance versus -2.93% for EM hard-currency bonds. The evolution of currencies can provide an explanation. Also, in spite of their typically positive correlation with US rates, EM yields have held up and partly absorbed the US Treasury bond shock. Against the backdrop of less supportive monetary policy and turbulent geopolitical situations, this divergence is quite unexpected and – in our opinion – reflects a change in market sentiment.
In the context of riskier equity markets, will EM local-currency bonds be next venue for risk-taking in 2022?
Positive macro and technical factors
First, mutual fund flows signal a change of heart. After significant outflows from the asset class in 2021, the first few weeks of 2022 have witnessed inflows into EM local-currency funds. Second, the primary market for hard-currency emerging debt usually sees a surge of new issuance in January – but this year January has been one of the least active months in terms of issuance. Understanding the fundamentals of this local-currency bond recovery is essential in order to gauge whether this EM bond rotation is sustainable. We think there are two key factors to consider:
- First, the technical position for EM localcurrency bonds was extremely supportive in December 2021 after nearly three months of uninterrupted selling-off. Most surveys currently show that investor positioning is currently near five-year lows both in terms of rates and currencies. To some extent, the short EM local-currency bond position is now crowded.
- Second, central banks in the emerging world (exAsia) raised interest rates throughout 2021 (see figure 1). This was well in advance of developed market central banks – reconstituting a large part of the carry, which has now recovered to around average historical levels. The EM macro backdrop made these hikes necessary to defend currency values, in opposition to the developed world. The hikes affected local curves, causing them to shift higher throughout 2021 and thus meaningfully increased the forex carry for EM currencies. The carry for hard-currency EM debt only started to climb in late December 2021 and into 2022, and to a much lesser extent. We think that this carry has created an appealing cushion against the current backdrop of higher rates.
FIG 1. EM index yield versus the US 10 Treasury -year yield (lhs) and spread (rhs)
Source: Bloomberg, JPMX, LOIM as at January 2022.
What happens now?
EM local-currency bonds offer a higher carry than a year ago, but to further entice investors their prospects will need to improve. The pandemic hit EMs hard, and the troubles in the China property sector has not helped their cuase. But what can be gathered from the latest economic trajectories for emerging economies is actually a lot more appealing than what has been visible recently.
Figure 2 shows the evolution of the Citi Surprise indices from 2021-2022. These indices measure the extent to which economists are positively or negatively ‘surprised’ by economic numbers. The world has tilted towards positive surprises since Q3 last year, while EM countries have only seen such an improvement since the beginning of 2022. The correlation between the recent carry recovery, better market sentiment and macro improvement is certainly not random. With Chinese authorities taking monetary and fiscal measures to counter current difficulties, we believe EMs present opportunities in 2022 and see many in EM local-currency bonds.
Chart 2. Citi Surprise indices (2021-2022)
Source: Bloomberg, LOIM as at January 2022.
| Simply put, with carry reconstituted carry and a better macro backdrop, the recent outperformance of EM local-currency bonds over their hard-currency peers should continue and represents another turn in the value rotation. |
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Nowcasting corner
The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick.
These indicators currently point to:
- Solid growth worldwide, with stronger momentum in the eurozone, while China lags. The US housing sector has marginally improved over the week.
- Inflation surprises are more likely to be positive but could also lose momentum across the three zones. The pace of moderating inflation pressure is becoming clearer in the US.
- Monetary policy is set to remain on the hawkish side, except in China. Our nowcasting indicator for the US and the eurozone remains in high territory. The risk of a positive monetary policy surprise is significant.
World growth nowcaster
World inflation nowcaster
World monetary policy nowcaster
Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).
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