Latin America Offers Opportunities for Bond Investors

Claudia Calich, manager of the M&G Emerging Markets Bond fund outlines what investors should expect from fixed income in 2018

M&G Investments 8 January, 2018 | 1:37PM

Rio de Janeiro

Emerging markets debt posted strong returns in 2017, driven by the stabilisation of fundamentals, the ongoing global economic recovery, a small rebound in commodity prices and a geopolitical environment in which the usual suspects – Trump,  North Korea, China – have behaved in a more benign fashion thus far.

One had to struggle to find an asset that produced negative returns and the only two that did, Venezuela and Turkish local bonds, reflected very different idiosyncratic factors.

While the strong returns we saw in the sector in 2017 are unlikely to be repeated in 2018, a number of factors continue to underline the relative attraction of the asset class. These include the higher yields available from emerging market bonds relative to their developed market counterparts, as well as the diversity of both the emerging market government and corporate bond universes.

Should the key tail-risks – such as US monetary policy, China, geopolitical risks and emerging market elections – remain on the backburner and volatility remain contained, the emerging market returns of 5.5-6.5% will continue to look attractive, especially considering the investment alternatives in other parts of global fixed income.

Falling Inflation Boosts Real Returns

Macroeconomic factors such as falling inflation have driven elevated real yields of many emerging countries, and a selective and flexible approach to asset allocation across different regions can present strong opportunities.

The credit quality of emerging market bond issuers is also expected to stabilise as economic growth forecasts edge upwards across most developed and developing countries. With improving fundamentals, this synchronised global economic outlook is encouraging for emerging bond markets, as emerging market credit ratings actions tend to correlate with growth rates.

US Monetary Policy Less of a Threat

At the same time, the relevant risks need to be monitored closely throughout 2018. These include higher US interest rates, although so far the Federal Reserve has tightened at a relatively slow and gradual pace that was widely anticipated, meaning reactions among emerging market bonds to the Fed’s hikes have been fairly muted.

Additionally, the higher US interest rate environment is less challenging for many emerging economies than in previous cycles, largely due to factors such as the improvements they have made to their current accounts, as well as adjustments towards having lower overall levels of US dollar-denominated debt. However, US rate increases may cause a headwind for other emerging economies, particularly those more dependent on US dollar funding.

Looking ahead, and provided the Fed does not fall behind the curve and needs to tighten more aggressively, the asset class should continue to withstand a gradual path of US tightening. Helpfully, for example, the real yields of many emerging market bonds look high enough to sustain their appeal against such an outlook.

Other risks for investors appeared to start being ‘priced out’ of emerging debt markets as 2017 progressed. These included the more pessimistic scenarios regarding the outlook for US/China relations under President Trump’s administration. The US has not, for example, named China as a currency manipulator nor has it engaged in a trade war.

However, the current renegotiation of the North American Free Trade Association (NAFTA) has yet to be finalised, with investors watching for any moves by the US to introduce tariffs. Elsewhere, while emerging market bonds have proved resilient to tension over North Korea’s armaments testing activity, the possible elevation of this risk remains an area to watch in 2018.

Unrestricted Approach Remains Key

A number of opportunities remain for investors across key emerging market regions, particularly in countries such as Brazil, Mexico, India and selective areas of Africa. Encouragingly, economic signals have shown improvement in several of Latin America’s larger markets, including Brazil and Mexico, despite the uncertainty for the latter surrounding NAFTA’s renegotiation.

In Brazil, economic growth picked up in 2017, despite renewed political turmoil, while declining local inflation has helped the country’s central bank to lower interest rates. These markets’ high real yields continue to support their appeal.

In terms of asset allocation across regions, the relative attraction of local currency sovereign debt has improved after some underperformance in 2016, based on factors such the strengthening of many emerging market currencies against the US dollar and the higher yields that can be found in this segment of the market. However, as we move into 2018 after another solid year for emerging market debt, taking a flexible and diverse approach to investing across the global emerging market opportunity set remains crucial to identifying strong returns.

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