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Fed rate hike expectations and emerging market bonds

Following Trump’s victory which pushed the US dollar towards a remarkable appreciation against major emerging market (EM) currencies, many market participants thought that the re-pricing in EM bonds would be as strong as the tapering tantrum, way back in June 2013.

However this time round, despite we did note substantial outflows, as the gains registered on a year-to-date basis are still strong, just below 17 per cent if we are tracking the Bank of America Merrill Lynch high yield emerging market index.

Expectedly, the main re-pricing was in Mexican bonds which were hit harshly following Trump’s victory, as market participants digested negatively Trump’s pre-electoral comments in which he pointed that trade relationships with Mexico might be heading towards a tough time.

On average Mexican bonds declined by five per cent. In my view despite the justified sell-off, the recent upward trend over the past month is also justified. In fact, most investors took opportunity of the attractive levels and dipped into solid names which were offering favorable risk-adjusted returns.   

As yields in European High yield continue to be relatively unattractive in terms of risk-adjusted returns, investors are still fetching attractive yields. In fact, decent inflows into EM bond funds were visible over the past month.

As I have opined in previous writings the sensitivity of EM bonds is primarily the currency movement. Realistically speaking this makes sense due to the higher re-financing issues EM issuers are faced due to a stronger dollar.

In fact, case in point was the slight dip which EM bonds experienced following the latest Federal Reserve meeting, in which an additional hike, from the original two projected by the Fed, was mentioned for 2017. This led to a stronger dollar and a re-pricing in EM debt.

The question I pose is whether such rally will be sustained for 2017. My perception is based on the fact that the recent rally in EM debt is primarily due to the fact of monetary easing in developed markets. In actual fact, EM credit fundamentals remain under some pressure.

The EM rating trend has remained firmly negative, especially for oil-related issuers, despite some breeding space over the recent stabilization in oil prices. Data compiled by Moody’s showed that the upgrade/downgrade ratio stands at 3:1 YTD, following a 5:1 ratio in 2015 (measured by debt volume across sovereign and corporate issuers).

However, what is interesting to point out is that in late December rallies in both greenback and US bond yields have stalled, adding that not only were expectations for stronger US growth already priced in, but that those expectations may also be getting too high.

Thus moving forward in 2017, investors might still find refuge in EM bonds, in terms of returns. EM debt seems to have already priced-in next year’s rate hikes and thus opportunities are in place.

What is surely not priced-in as yet, is the possible faster pace of US inflation expectations that might trigger additional unexpected rate hikes. That said to-date inflation expectations for 2017 seem to be priced-in. My picks for 2017 are Indonesia, Russia and Brazil, however being selective and opting for a bottom-up approach might be imperative going forward.

Disclaimer: This article was issued by Jordan Portelli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.

 

 

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