The outperformance of local currency government bonds has fizzled out in recent weeks as the rally in emerging market (EM) currencies has come off the boil.
After posting a total return of about 10 percent in US dollar terms between Sept. 1 and Feb. 1, they have been broadly flat since, underperforming hard-currency government and corporate bonds.
We have expressed a preference for local currency bonds in the past, and so this raises questions about whether that call has now run its course.
There has been a general plateau in risk markets in recent weeks as investors await the next major catalyst for asset prices. EM currencies have been no different. Some form of trade deal between the United States and China is now surely priced into markets, and a pause in Fed tightening must also be largely baked into the cake.
The recent rebound of the US dollar against EM currencies, coupled with a decline in the yields of US Treasuries, suggests that investors are still concerned about a global economic slowdown and that this will be the major driving force of EM asset prices.
However, we continue to think that concerns about the global economy are overdone and that, while there is probably going to be a further deceleration in the near term, activity will improve as the year progresses.
Nowhere is our story more fitting than in China, and the weaker-than-expected February activity data that were published on March 14 will have done nothing to ease fears about the health of the economy there.
But while investors are yet to be fully convinced that China’s economy will stage a recovery this year, our leading indicators continue to suggest that there will be tangible signs of improvement in the not-too-distant future.
We also think that the US economy is in relatively good shape, but the pace of growth will slow and the recent run of poor data means there is clearly a chance that the Fed will pause its tightening cycle for longer than we anticipate.
This ought to be negative for the US dollar – and positive for EM.
Such a global backdrop would be reminiscent of 2016, a period during which EM local currency bonds fared well. This, coupled with the fact that many major EMs offer high real interest rates, means that we remain positive on the asset class.
Last year, we argued that the turbulent global backdrop meant that better entry points into local currency markets would present themselves. We are probably close to that time.
That being said, currency movements will clearly be important and we reiterate our view that investors should be selective.
In January we published a framework for thinking about EM currencies. While not particularly scientific, the framework picked out those EM currencies that have out- and underperformed this year.
The latest figures suggest that the Mexican peso will fare well, given that it is backed by high real rates, and negative positioning will unwind if the economic and political scenario proves to be “less bad” than investors fear.
A lot of good news is now priced into the Russian ruble, but it is still backed by high carry and rising oil prices.
Meanwhile, the Indonesian rupiah could also fare well, given that the upcoming presidential election appears to be a foregone conclusion.
But we would exercise caution over other EMs where upcoming elections are less clear-cut – Argentina, India and South Africa. Meanwhile, Brazil’s pension reform leaves scope for disappointment.
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