Since the US election results became clear, market participants have felt comfortable taking on more risk in their portfolios with cash being put to work ahead of year-end. This market move has been supercharged by announcements that a vaccine is close. These developments have been particularly beneficial to emerging markets (EM), where president-elect Joe Biden is seen as a globalist and thus likely to undo some of the disruptions brought on by the Trump administration. Global trade stands to benefit, also helped by the news that an Asian free trade agreement – the Regional Comprehensive Economic Partnership (RCEP) – has been signed.
So the world looks like a slightly happier place for EM with growth expected to pick up in 2021 but, so far, there are only isolated signs of inflation. The PriceStats® indicators, developed by State Street Global Markets, suggest that there are few pressures on the inflation front for EM nations outside of Brazil and Turkey. As such, we expect a period of more balanced monetary policy with some central banks, such as Turkey, raising rates while others remain in easing mode, such as Indonesia. The enigma in the EM world remains China, where an expanding economy in 2020 has resulted in the yield on 10-year bonds pushing 80bp higher from the lows seen in the immediate aftermath of the COVID-19 crisis. This comes despite signs that inflation remains contained and a strengthening of the yuan.
The better growth outlook may cause some investors to prefer hard currency funds, where returns are more about credit quality and where stronger growth should ensure countries have an improved ability to service their debt. Indeed, the ICE BofA 0-5 Year EM USD Government Bond ex-144a Index has returned 2% year to date in USD unhedged terms despite its low duration of under 2.5 years.1 Given a yield to worst of more than 2.3%, this is one way of providing a portfolio with an uplift to running yield while keeping duration risk low.
Upside and Downside of a Declining USD
That said, a key view of State Street Global Markets is that the USD is going to continue its depreciation. The combination of the USD enjoying little support from interest rate differentials, coupled with hopes of a return to a more normal environment, could erode the appeal of the USD as a safe haven. As the chart below illustrates, this would favour local currency bonds. There is an especially close inverse relationship between changes in the trade-weighted USD (DXY) and returns on the local currency index, but much less so for the hard currency index.