Role Reversal: Emerging Market Debt Proving Stable
Emerging markets continue to face the headwinds of COVID and high inflation. However, the resilience shown so far in 2022 hints that emerging market central banks are perceived to be ahead in the fight against inflation, and this is lending some stability to bonds and local market currencies.
Roles reversed – emerging market debt in 2021 vs. 2022
The start of a Federal Reserve (Fed) tightening cycle has typically been quite a traumatic experience for emerging market debt (EMD) investors. The Bloomberg EM Local Currency Liquid Government Index fell more than 13% from the average levels seen in H1 2015 in the run-up to the December 2015 rate rise. Fears of a repeat performance coupled with the unexpected strength of the USD kept investors on the sidelines in 2021. See the Q1 2022 Bond Compass, which shows that real money investors were net sellers of EM local currency bonds relative to benchmarks between spring 2021 and year end.
The start to 2022 represents something of a role reversal. Fears over an aggressive Fed tightening have increased, yet EM debt has proved remarkably stable. It is the developed markets (DM) that have seen significant volatility and price losses in both bond and equity markets. Increased risk appetite at the start of the year may have encouraged some investors to re-enter emerging markets but there are also some key reasons why the forces that buffeted EMD in 2021 may be abating.
EM central banks are ahead of the curve
The Fed and other DM central banks are under pressure, for the main part because the market believes they are behind the curve. Inflation proved not to be transitory (as promised), rose more than expected and many central banks have retained super-stimulatory policy settings despite tight labour markets. EM central banks, however, have responded to inflation, lifting rates off lows despite, in many cases, the quite severe economic impact of COVID. Figure 1, which is a diffusion index of central bank rate changes, suggests peak tightening pressure was seen in mid-December 2021 and is now starting to fade.
Figure 1: EM Central Bank Policy Tightening Eases from the Highs
It may be premature to call an end to the inflation surge that has so troubled central banks but there are some hints that peak inflation pressures for many EM nations may now be behind us. As State Street Global Markets highlighted in a recent note, the indicator of price pressures drawn from online data (PriceStats®) is pointing to some fading of the inflationary impulse in several large EM nations.1
Key observations are that non-food supermarket prices in China remain subdued, that inflation in South Korea and Mexico may have peaked at the end of 2021, and that the PriceStats series in Brazil has seen a meaningful decline. So while high energy prices and supply chain disruptions will keep inflation at elevated levels, there are some markers that pressures should start to ease during the early part of 2022.
The strength of the USD proved to be a constant thorn in the side of EM investors in 2021. Over the course of the year, the depreciation of EM currencies relative to the USD acted as a 5.5% drag on performance for the Bloomberg EM Local Currency Liquid Government Index. The DXY (the trade-weighted USD) hit its highest level since mid-2020 in early 2022, on fears over an aggressive Fed policy tightening.
Since then, the price of the December Fed Funds future has fallen further, implying the market believes that even more Fed tightening will be delivered this year, but the USD has fallen back. While a big risk-off move would favour the USD, this lack of traction from increased rate expectations does hint that the USD may struggle to push higher unless the Fed delivers a real shock, such as tightening policy in bigger-than-anticipated 50bp clips.
Locking in higher yields
Bond yields globally are rising but the trick for fixed income investors is to lock in higher yields while trying to minimise exposure to declining asset values. Investors in DMs are likely to remain cautious around building long positions and locking in improved yield levels before there is a little more clarity on the inflation picture.
In contrast, EM debt has proved remarkably stable. Yields on the Bloomberg EM Local Currency Liquid Government Index have moved around 10bp higher since the end of 2021, to 5.3%, against a more than 50bp increase for the Bloomberg US Treasury Index to 1.75%. By opting for EM versus US Treasuries, investors would lock in a yield advantage of over 350bp and, based on the past few weeks of price action, also have more stable total returns.
Chart 2: EM Yield to Worst at highest since 2019 and Spreads to Treasuries are Wide Despite Recent Sell-Off
Emerging markets continue to face the headwinds of COVID and high inflation. Second guessing where the USD may move is also a risk. However, the resilience shown so far in 2022 hints that EM central banks are perceived to be ahead in the fight against inflation, and this is lending some stability to bonds and local market currencies.
Stability coupled with yield levels that are at their highest since mid-2019 should aid confidence that EM local currency debt can perform well in 2022 as inflation starts to decline. For investors less confident that inflation pressures will ease, index-linked bonds can provide a degree of protection (see the Q1 2022 Bond Compass for more details).
How to play this theme
Investors looking to access EM debt can do so with SPDR ETFs. To learn more about these funds, and to view full performance histories, please click on the fund names below.
1 Source: State Street Global Markets, EM Inflation in Focus: Rollover Relief, February 2022.
2 Prior to 1 February 2022, the Fund was known as SPDR Bloomberg Barclays Emerging Markets Local Bond UCITS ETF (Dist), tracking the Bloomberg Barclays Emerging Markets Local Currency Liquid Government Bond Index.
3 Prior to 1 February 2022, the Fund was known as SPDR Bloomberg Barclays Emerging Markets Local Bond USD Base CCY Hdg to EUR UCITS ETF (Acc), tracking the Bloomberg Barclays Emerging Markets Local Currency Liquid Government Bond Index unhedged USD base hedged into EUR.
4 Prior to 1 February 2022, the Fund was known as SPDR Bloomberg Barclays EM Inflation Linked Local Bond UCITS ETF (Dist), tracking the Bloomberg Barclays Emerging Markets Inflation Linked 20% Capped Bond Index.
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