Fixed income
16 Jul 2019 | By Delphine Arrighi

Why the emerging market debt rally has further to go

Widespread cuts in interest rates may be in prospect, and, despite the rally, selected credits may be still cheap.

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Emerging market debt has rallied strongly this year. So far, most of the gains have been in hard currency emerging market debt.

But in June, local currency emerging market debt finally staged a long-awaited catch up with its hard currency cousin. The local currency index returned 5% over the month, bringing its year-to-date return to 9%. Meanwhile, the hard currency index continued its steady climb, up 3% in June, and up 12% year-to-date.

Once again, the dovish stance of the US Federal Reserve (Fed) was the green light that markets were waiting for. However, we believe that either the Fed will have to deliver on substantial rate cuts, or economic data in emerging markets will have to pick up, if the rally in local currency debt is to be sustained. The announcement of strong US job data for June does not necessarily contradict the scenario of imminent Fed rate cuts, but it does highlight the danger that the market could be pricing in too much too quickly. There is a risk that the Fed could disappoint.

Further rate cuts expected

Recent data shows an unequivocal economic slowdown across emerging markets on the back of lower exports and orders. China is yet to stabilise, let alone to pick up. Growth forecasts for the year have now been revised down pretty much across the board, reinforcing the view that further stimulus will be necessary. India and the Philippines have jumped in first with frontloaded rate cuts, with the prospect of more to come. We think Indonesia, Russia, South Africa, Malaysia, Turkey and Egypt will follow in July. Brazil might wait for the completion of its pension reform, and that Mexico will wait for the Fed, if not longer, before unwinding some of its previous tightening.

The Philippines continues to have the highest real rates of all countries in the emerging markets debt index. Inflation has fallen sharply, with the Philippines Consumer Price Index (CPI) dropping like a stone below the 3% midpoint target range for the first time since December 2017, leaving room for a prudent central bank to cut rates by another 50 basis points (bp) in August, and again in the fourth quarter.

Similarly, in Indonesia the central bank has ample room to unwind some of the pre-emptive tightening of last year, undertaken more to shore up the currency than to prevent the build-up of inflationary pressures, which were never there. With 175bp of hikes last year, we see room for cuts of at least 50bp or more this year, even though growth is doing fine, with manufacturing PMI rebounding somewhat and Q1 GDP only slightly below expectations. The government continues to decrease oil subsidies to meet its primary deficit target of 1.8%, but that should have only a limited impact on CPI which, hovering around 3%, gives Indonesian government bonds a lot of room to appreciate still.

In South Korea, some Monetary Policy Committee members have turned more dovish, increasing the chances of a rate cut in September (or even in August, were the Fed to cut in July).

In contrast, in central and eastern Europe, inflation continues to surprise to the upside, and while this may not be enough to trigger rate hikes, it at least prevents talk of easing in the region. In our view, central and eastern European central banks will stay on hold for the foreseeable future. We also think Colombia will stay on hold given its still decent growth and widening current account deficit.

Argentina still cheap

Given this scenario, which countries are attractive?

In the hard currency space, Argentina is one of the few credits that still screams “cheap”, even though the market still prices in a risk of default should Cristina Fernandez de Kirchner come back into power. Lower than expected inflation, and a more stable peso, has allowed the central bank to “gradually” ease its policy rate: although when starting from 71%, gradual means a whopping 1100bp in a month. Still, President Macri’s recovery in the polls ahead of the primaries, supportive export proceeds, and greater flexibility in the central bank’s intervention mechanism, should help keep the currency from weakening in the near term, in turn allowing for further easing, albeit at a slower pace.

While we continue to like Nigeria, Egypt, Ukraine, Indonesia and Russia, we are less keen on the Middle East, where valuations are tight and vulnerable to higher US Treasury yields, and where geopolitical risk dominates.

We are also less than keen on Turkey, despite the potential resolution of the S-400 missile crisis between President Erdogan and President Trump. Turkey has a fiscal deficit running at 4.5% and Erdogan recently removed the central bank governor in order to finance it. That erratic move forced the central bank to burn another US$1.4bn in reserves overnight to stabilise the lira, which brings Turkey closer to the brink of a serious cash flow problem with its net liquid reserves running at multi-year lows.

A favoured asset class

Emerging market bond fund flows continue to confirm our bullish outlook overall. June saw a small pick-up in local currency, bringing inflows year-to-date there to US$3.6bn. But the bulk continues to flow into hard currency, totalling US$20bn year-to-date, or US$26bn across all EMD, a new record after 2017. By way of comparison, in 2017 there were total inflows of US$60.5bn into the asset class, split between US$36bn in hard currency and US$17bn in local. So this year’s rally in emerging market debt may yet have some way to go.

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