Emerging market local currency bond funds attracted an average of $400m (€292m) a week through the summer, according to EPFR data, as investors sought income and safety, both of which are scarce in the current climate. Despite faltering in early September, strong inflows are expected to resume through the rest of the year in a reflection that the global balance of power is changing and the attractions of growth economies are set to be long-term and enduring.
Most interest is focused on local currencies because investors feel there is more upside potential in currency appreciation, and remain wary of the dollar and euro. Emerging market currencies are expected to appreciate about 3 to 5 per cent per annum for the next five years in something of a self-fulfilling prophesy as flows to emerging markets continue to grow.
In comparison with their Western peers, emerging market bonds offer the twin attractions of both stronger balance sheets and juicier yields. The JPMorgan GBI-EM Index is currently yielding 6.20 per cent compared with 0.8 per cent for five-year US Treasuries and 0.85 per cent for five-year German Bunds.
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The yield outlook is encouraging because rates in many growth countries were raised in the first half of the year on central bank concern about inflation, but that may have been overdone and some are now at a point where they may start to reverse those decisions.
“Combining the two drivers, emerging market local currency bonds can be expected to show yearly total returns close to 10 per cent for the next five years, or even 13 per cent in our more bullish scenario,” says Ernesto Bettoni, investment specialist, emerging markets fixed income at BNP Paribas Investment Partners.
INFLATION FEARS
Mr Bettoni points out that inflation has been a major concern at times over the past three years, but in each instance the market turned out to have been overly-negative. In October 2008, and again in May 2010 and January to February 2010, most yield curves in emerging markets steepened because of expectations that central banks would raise rates drastically.
Each of the 40 growth markets is markedly different however. Not every country has experienced inflation and some central banks are more proactive than others.
It remains the case that inflation is more of a threat in Asia than Latin America, and there is still a perceived risk in some regions of insufficient tightening.
“It is important for local authorities to continue to normalise policy in economies where activity has returned to its long-term potential,” says Michael Hasenstab, portfolio manager at Franklin Templeton Investments.
“This can be a politically sensitive issue, but it is crucial in order to avoid overheating economies, inflationary pressures and asset price bubbles over the next several years,” he explains. “Economic outperformance, particularly in Asia ex-Japan, is attracting record levels of capital, which has been fuelled by very loose monetary policy in the developed world. Against this background, economic policy must remain forward looking, and policymakers must not become complacent due to temporarily contained price pressures.”
Within local currency debt, Latin America stands out as a favorite region, with Brazil and Mexico the flavour of the month.
“Brazil is showing a strong inflationary impulse at around 7 per cent, while its monetary policy rate is 12.5 per cent so Brazil could cut rates by 5 per cent and still have positive front end real rates,” says Michael Gomez, co-head of the emerging markets portfolio management team at Pimco.
“The central bank therefore has much more room to ease interest rates than the ECB (European Central Bank) as one example, which can cut by only 1.5 per cent.”
US DOWNGRADE
In a fundamental reversal from a decade ago, the biggest risk factors now stem from developed countries. US growth and employment figures have been disappointing, and the recent US downgrade by ratings agencies has exacerbated weakness in its equity markets and the dollar.
“The developed world has been told that there will be lower rates for longer,” says Simon Lue-Fong, head of Pictet’s emerging debt team, which has $19bn under management.
“The Fed has indicated that rates will be held near zero until mid-2013 so we know rates will be zero at the front end, forcing investors to look for yield,” he adds.
This is the first time the Federal Reserve has promised to peg its exceptionally low rates to a specific date, and it may be an indication of the level of difficulties ahead, particularly as Fed chairman Ben Bernanke previously expected the economy to rebound in the second half of the year.
“The best hope for the US is slow growth and the worst is a real depression,” says Jerome Booth, head of research at Ashmore.
“Emerging markets are therefore attractive not just for what we used to call ‘risk adjusted returns’, but fundamentally to reduce risk. Investors should be taking money out of the crash zone, but denial (that this is the situation) is a powerful behavioural characteristic,” he explains.
