Resilient debt markets belie talk of a “perfect storm” for EMs
When it comes to emerging markets (EMs), there is no shortage of issues for international investors to fret about.
The latest development to roil markets was the highly unexpected decision on Tuesday by China’s central bank to devalue the renminbi by nearly 2 per cent - the sharpest adjustment in two decades - in a thinly veiled effort to stimulate the country’s sagging economy.
The move put further strain on equity, currency and commodity markets and sparked fears of a more intense and destabilising battle in global foreign exchange markets in which countries have been intentionally weakening their currencies to boost their exporters’ competitiveness. On Wednesday, Vietnam’s central bank widened the trading band for its own currency, the dong.
Over the past three months, EM stocks have been hammered, falling 12.5 per cent (compared with a 2 per cent decline in the benchmark US S&P 500 index), with Chinese and Brazilian stocks performing the worst. According to JP Morgan, EM equity funds suffered outflows of nearly US$3 billion last week, taking this year’s total redemptions to nearly $21 billion.
EM currencies, moreover, are under severe strain. The devaluation in the yuan caused the sharpest two-day sell-off in Asian currencies since the region’s financial crisis in 1997-98. The Malaysian ringgit - already under pressure because of the renewed decline in oil prices - has fallen more than 5 per cent against the dollar since the beginning of this month while the Indonesian rupiah is trading at its weakest level since 1998.
Commodity-rich developing countries with weak fundamentals have suffered the steepest falls in their currencies. The Russian rouble and the Brazilian real have dropped 30 per cent and 16 per cent respectively since mid-May.
According to a recent report by the Institute of International Finance (IIF), EMs are now facing “what appears to be a perfect storm”, buffeted by the fallout from a strengthening dollar, mounting concerns about China, the sell-off in commodity markets and a plethora of country-specific risks.
Yet if sentiment towards developing economies is so dire, then why are EM bond funds still attracting inflows?
According to JP Morgan, EM debt funds have attracted nearly $13 billion in inflows this year, compared with $11 billion for 2014 as a whole. Although the bulk of these inflows have gone into dollar-denominated bond funds, net flows into local currency debt funds - which have suffered much more due to the sharp declines in EM currencies this year - are still in positive territory.
Just as importantly, the average spread on EM dollar-denominated bonds over 10-year US Treasuries, as measured by JP Morgan’s benchmark EM government bond index (EMBIG), has risen just 30 basis points this year, while EM corporate bond spreads have even fallen slightly.
While there has been a significant deterioration in sentiment towards EM debt - both corporate and sovereign - over the past month or so, the average yield on EM local currency bonds, as measured by JP Morgan’s EM local currency bond index (GBI-EM), is currently lower than where it stood in February 2014 when EM assets succumbed to widespread contagion partly due to fears about the fallout from a rise in US interest rates.
Indeed many EM bond markets are proving remarkably resilient - particularly those in central and east Europe whose debt markets are benefiting the most from the launch of the European Central Bank’s quantitative easing (QE) programme in March.
Yields on local 10-year Polish and Hungarian bonds currently stand at just 2.9 per cent and 3.6 per cent respectively compared with nearly 5 per cent and 6.8 per cent in early September 2013. India’s 10-year bond yield, meanwhile, has barely budged this year. Even 10-year yields on the domestic bonds of Malaysia - one of the hardest hit EMs in recent months - have remained stable.
Some EM issuers, moreover, have been able to sell so-called “century bonds” this year, with Mexico selling 100-year debt in April at a yield of just 4.2 per cent and, more surprisingly, Petrobras, the scandal-plagued Brazilian oil company, following suit in June.
While there is no question that sentiment towards the EM asset class has suffered enormously over the past several weeks, bond markets continue to fare considerably better than currencies and equities.
This is mostly due to the strong commitment of long-term institutional - as opposed to retail - investors, particularly local ones such as domestic pension funds and insurance firms which now own the bulk of EM debt and are much less likely to sell during bouts of financial turmoil.
While the EM seas are getting choppier by the day, most bond markets are weathering the turbulence remarkably well – at least for the time being.
Nicholas Spiro is managing director of Spiro Sovereign Strategy