Emerging market bonds have been hit by a significant sell-off over the past month as investors grew concerned that the Federal Reserve could ease its stimulus efforts and fears mounted of a new credit crunch in China.
But despite valuations in the asset class falling to more attractive levels, some commentators are reluctant to see the correction as a viable buying opportunity.
Capital Economics says dollar-denominated emerging market bonds fell by 10.5 per cent in value between the start of 2013 and 25 June, while local currency bonds dropped by 0.8 per cent. Losses in recent weeks have been harsh, as investors fled the asset class.
“Dollar-denominated emerging market bonds have come under fire over the past month. The JP Morgan EMBI Global Index has returned about minus 9 per cent, with large losses again being experienced across the major emerging market regions,” the consultancy says.
“Local currency emerging market bonds have not gone unscathed. The JP Morgan GBI-EM Broad Index has returned about minus 4 per cent over the past month. However, there has been greater regional differentiation.”
Some investors could be tempted to view such a dip as a buying opportunity and move back into EMD. However, not all commentators are bullish on the outlook for the asset class.
M&G bond fund manager Mike Riddell argues that the traditional reasons used to justify the attractiveness of EMD – strong growth, good demographics, low government debt levels and being an ‘under-owned asset class’ – are “broadly irrelevant”.
“Thailand and Malaysia had great demographics in the mid 1990s, but that didn’t prevent the Asian financial crisis. Ireland and Spain had very little government indebtedness prior to 2008, but that didn’t help much either,” the manager says.
“EM debt returns are instead largely a function of US Treasury yields, the US dollar and global risk appetite, where the mix varies depending upon whether you’re looking at EM local currency debt, or EM external sovereign or corporate debt.”
Riddell notes that speculation over the Fed’s intentions to ‘taper’ its $85bn-a-month bond-buying effort have been cited as prompting much of the flows away from the asset class. However, he says that Japan and China are important too.
Japanese investors have been selling foreign bonds, including EMD, at at “near record pace” since the country unveiled its massive stimulus effort, the manager says. This has exerted downward pressure on emerging market bonds.
But Riddell finds the changing China story the “most worrying”, as he believes the world’s second largest economy will enter a “significant slowdown” in the coming months and years – which will have “profound effects” for EMD.
“Market participants still believe that China can grow at 7 per cent plus ad infinitum, but I can’t see any scenario under which this is actually possible,” he says. “If you like clichés, China is in effect ‘turning Japanese’, but unlike Japan, it has grown old before it has grown rich.”
Despite the recent sell-off in EMD, Riddell does not foresee a particular strong investment case for the asset class.
“EM debt now offers relatively better value than a few months ago, and it therefore makes sense to be less bearish on an asset class that we have long argued has been in a bubble. That doesn’t mean I’m bullish,” he says.
“Following the recent sell off, the vast majority of investors who have piled into EM debt in the last three years are underwater, and it will be interesting to see how they react.”
ING Investment Management senior emerging market strategist Maarten-Jan Bakkum highlights a number of structural negatives in emerging markets that reduce the attractiveness of EMD.
These include large current account deficits, unsustainable subsidy schemes, negative competitiveness trends, regulatory uncertainties and counterproductive state intervention in the economy.
Bakkum says: “Growth in emerging markets in the past years has been driven primarily by Chinese demand and carry-trade-related flows.
“Both sources of growth are coming under more pressure now; the former because of increasing evidence of the structural slowdown in China and the latter because of increasing market nervousness about the Fed’s QE policy.”
ING Investment Management is underweight both emerging market bonds and emerging market equities. Although it likes Mexico, seeing it as the only country with “a credible structural reform momentum”, the firm argues that macro imbalances are widening in areas such as Russia, South Africa and Brazil.
“The investment climate is deteriorating and industry competitiveness is declining. Currently, we see a poor reform momentum throughout the emerging world and few indications that things are improving,” Bakkum adds.
Ratings agency Moody’s Investors Service also believes that the weakness in EMD is “no buying opportunity”.
A note by Moody’s Analytics sovereign credit analyst Jerry Tempelman notes that the Fed clarified that it is not in a rush to unwind QE and Chinese authorities took measures to alleviate its potential credit crunch, which helped to calm some parts of the bond market.
However, the Chinese move was only to alleviate pressure in the short term. The country is still aiming to engineer a soft landing through limiting credit growth its considers excessive, which will have significant repercussions for EMD as an asset class.
“For that reason, we do not consider the recent market quite the same buying opportunity for emerging market debt as it may be for other asset classes, such as high yield corporate debt,” Tempelman concludes.