Emerging market debt in the spotlight as hunt for yield intensifies
With core bond yields heading even lower, many investors are turning to both hard and local currency emerging market debt in their search for yields, says Aaron Grehan.
Heightened political uncertainty and anaemic global growth are forcing global rates to new lows, and in the process enhancing the appeal of emerging market assets. Core government bond yields plumbed new depths following the UK’s vote to leave the EU in the 23 June referendum.
While emerging market stocks, bonds and currencies initially came under pressure following the vote, they recovered quickly as the post-'Brexit' environment increased the likelihood of a further wave of monetary easing globally. Expectations of when the Federal Reserve will next increase interest rates have already receded, while an aggressive rate hiking cycle can now be ruled out. Meanwhile, further monetary easing is anticipated in Europe and Japan.
Yet the Aviva Investors’ House View forecasts that global growth should remain largely stable for the foreseeable future. US payroll figures for June exceeded forecasts, highlighting that the US recovery remains steady if unspectacular. Meanwhile, although China’s reform programme seems to be on hold in the face of more immediate economic challenges, Beijing’s stimulus measures should ensure a soft landing for the economy and a stable growth outlook.
The prospect of ‘lower for longer’ US interest rates is alleviating upward pressure on the dollar, providing another tailwind for emerging market assets. Adding to the positive sentiment, the outlook for commodities, which remain a key driver of many developing economies, is stable. While we continue to expect that commodity prices will remain ‘lower for longer’, price stability is supportive for emerging markets and creates opportunities in a number of countries.
Opportunities in Asia and Latin America
Our focus is on countries with a positive political and economic backdrop, where sound fundamentals offer justification for yields tracking core government bonds lower. The market currently favours longer-duration assets and higher beta assets, which should benefit from yield compression. In terms of regions, Asia and Latin America offer attractive opportunities among sovereigns and corporates in both hard and local currencies. Sovereigns that we favour in these regions include Argentina and Indonesia.
Emerging Europe could be affected by any further uncertainty and fallout from Brexit. While economic trends in Poland, for example, remain favourable, the government estimates that Brexit could shave up to one per cent of GDP growth. Meanwhile, whilst Russia is less vulnerable to the impact of Brexit, it has limited potential for further gains following a strong performance in asset prices over the past 18 months. The recent coup attempt in Turkey, meanwhile, is a reminder, that political risk remains an ongoing concern in some emerging markets. However, and unlike in the developed world, political instability tends to be factored in to asset valuations, offering investors a measure of compensation for the risk.
Longer-term outlook for emerging market debt remains positive
Elevated levels of developed market political risk, with all that means for monetary policy and core government bond yields, are likely to remain a driver of financial markets in 2016 and 2017. The US, France, Germany and the Netherlands face elections in the coming year, while the new UK premier will have to begin negotiating the terms of Brexit. A referendum in Italy in October could cause fresh elections that propel the Five Star Movement, which is opposed to Italy’s membership of the euro in its current form, into government. This political uncertainty should ensure that core government bond yields remain low, while the attractive risk premium offered to invest in developing markets will support the appeal of emerging markets.
Technical factors continue to be beneficial. While we have seen a large amount of issuance from the Middle East and the likes of Argentina this year, the overall volume has been easily absorbed. Moreover, we anticipate a limited supply of emerging debt, particularly denominated in hard currency, coming onto the market during the remainder of this year. At the same time, asset flows have rebounded strongly this year, returning to their long-term average, a trend that is further supporting the technical picture. Moreover, inflows are expected to continue increasing significantly from current levels during the rest of this year.
The search for yield is likely to stay in place for much longer than investors could have anticipated at the beginning of this year. Indeed, the hunt for yield is intensifying as political uncertainty, so long a feature of emerging markets, becomes more prevalent in the developed world. Given fundamental stability, supportive technical factors and attractive valuations, and the global macroeconomic environment, the prospects for emerging-market assets into the year end appear positive.
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- Core bond yields are likely to remain low given elevated levels of political uncertainty and continued supportive policy
- The prospect of further monetary easing globally will fuel the search for yield
- The outlook for the US dollar, commodity prices and global growth should provide further support to emerging market assets
- The current environment favours longer-duration assets and higher beta assets, which should benefit from yield compression