The curse of the developed world central banks — low inflation — is turning out to be the boon for emerging markets, and their bonds.
That’s making things very different for the asset class compared with past cycles of Federal Reserve interest-rate increases. Perhaps since the Fed’s monetary tightening in the 1980s helped kick off the Latin American debt crisis, prospects of US rate hikes have stoked fears of emerging-market sell-offs; the 2013 taper tantrum only reinforced the idea.
Yet this time, the same dynamic that’s making Fed policy “normalisation” a drawn out and gradual affair — stubbornly low increases in consumer prices — is also affecting emerging markets, which more typically find themselves battling to keep inflation low. Part of that is subdued prices of commodities, which are often priced in dollars and can stoke prices in poorer countries when their currencies slide, as has happened during past Fed tightening.
The pattern has widened the gap between real central bank policy rates in emerging markets — which are adjusted for inflation — and those in the biggest developed nations to almost 4 percentage points as of June, according to the Oxford Economics research group. That’s up from less than 1.5 percentage point when the taper tantrum began in May 2013.
“Portfolio flows into emerging-market local currency assets have been surging, staying remarkably resilient to the slightly hawkish tilt of major central banks last month,” analysts Nafez Zouk and Gaurav Saroliya of Oxford Economics said in a report last week. “Real interest rates remain high in the major emerging markets as inflation has declined.”
Emerging-bond rally about to start on rate cuts
A model for capital flows into emerging-market debt constructed by Goldman Sachs Group Inc. analysts signals that the trend of inflows is set to continue. Inflows amounted to about 0.6 per cent of gross domestic product in the first quarter of 2017, and are poised to keep rising to 1 per cent, the bank’s model showed last month.
“There’s a noticeable gap between real yields in developed and emerging markets, and it highlights that EM local government debt is attractive,” said Andre de Silva, head of emerging-markets rates research at HSBC Holdings Plc in Hong Kong.
India, which has been so hot a bond market for foreign investors that they’ve exhausted the caps the government places on overseas purchases, exemplifies the current trend.
Low inflation spurred the Reserve Bank of India to cut its benchmark repurchase rate by 25 basis points to 6 per cent last week. Expectations for a move had seen yields on 10-year government bonds drop more than 50 basis points from a May high. That high came ahead of a Fed rate hike in June that was the fourth so far since the cycle began in 2015.
By contrast, during the Fed’s 2004-06 rate-hike period, Indian yields climbed more than 200 basis points amid accelerating inflation.
The current pricing pattern in India can also be seen in other markets such as Russia and Brazil.
Tuan Huynh, chief investment officer for Asia Pacific at the wealth management division of Deutsche Bank AG, recommends emerging-market debt as one of the firm’s few overweights in fixed income.
“When I look at the emerging-market fundamentals, they have clearly improved over the last four or five years,” Huynh said in a phone interview from Singapore. “The market is much better prepared” than ahead of the taper tantrum, he said.
Huynh recommends holding shorter-duration emerging-market debt, keeping an eye on any potential impact of the Fed’s plans to scale down its $4.5 trillion balance sheet over the next few years.