Asian Bond Watch: Still Riding the Emerging Market Debt Bounce-Back

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While we were still in a period of shock and awe during the March/April period, the latter parts of 2Q20 were better described as a period of healing and adjustment. Significant rate cuts from the developed market (DM) and emerging market (EM) central banks illustrate the global scale of the economic challenges created by COVID-19.

The latest economic projections from the IMF signal shrinking output from virtually every country and region that it forecasts. Much of this loss in growth is expected to bounce back in the following year, although advanced economies are expected to lag the emerging markets in their speed of recovery.

Aggressive expansion of central bank balance sheets has stabilised markets, reducing the need for portfolio hedging and keeping a lid on bond yields. The overall interest rate environment is near its all-time lowest, while policy rates are not expected to rise for up to, and possibly beyond, five years in most of the largest economies.

The markets remain very much in flux, parsing the opposing forces created by the ongoing pandemic with aggressive fiscal and monetary intervention.

Aggressive fiscal and monetary intervention
The US fiscal response to COVID-19 has been one of the most aggressive in the country’s history and leads the global response from an absolute and relative perspective. There have been four separate pieces of legislation passed by Congress, resulting in almost US$3 trillion in funding support for individuals, corporations and state and local governments.

EM central banks have been equally as active as their DM counterparts in addressing collapsing economic activity in the face of COVID-19. Their one advantage has been generally higher rates, which allowed them to cut rates significantly since March. Quantitative easing has also been rolled out by a handful of EM banks. While all of these actions may help stabilise local markets, investors recognise potential downsides, including eroding rate differentials and inflation, along with a potentially more challenging medical emergency.

While we have seen a healing in various risk assets over the past quarter, EM bond flows do not yet show this enthusiasm flowing into DMs. Overall flows remain squarely in the selling camp. There is little distinction between regions, so real money does not appear ready to pick winners and losers yet, instead simply allocating across the asset class. If the risk rally moves beyond DM, better EM bonds flows may signal a broadening of global risk-taking.

Focusing on stability and diversification: Looking for the Asian skew
We remain positive on emerging market debt, as we saw scope for a bounce in risk assets as the crisis receded. As of 15 July 2020, the Bloomberg Barclays EM Local Currency Liquid Government Bond Index has returned 9.45% since the end of March 2020 in USD unhedged terms.1

Despite this strong bounce, less developed markets have struggled to completely shake off the pandemic. High COVID-19 infection rates in countries such as Brazil continue to cast a shadow over the wider asset class. Nevertheless, emerging markets are diverse and, while some continue to suffer, others have been more effective at containing the outbreak. This diversity makes emerging market debt a compelling investment idea, with three key drivers.

First, yields are relatively attractive in an otherwise lower-for-longer yield environment. Returns solely accounted for by coupons were 2.38% in the first half of the year for the Bloomberg Barclays EM Local Currency Liquid Government Bond Index2. The index now has a yield to worst of 3.67%1, low by historical standards but considerably higher than anything available in developed markets outside of high yield bonds.

Second, uncertainty around the re-emergence of COVID-19 and wider geopolitical issues have resulted in market participants being underweight risk assets. As investors look for yield, this long-term underweight may gradually be reduced if markets remain stable and a recovery emerges more solidly.

And third, with yields lower, future returns are expected to be led by a rebound in currency. There have been some signs of recovery but the currency basket for the Bloomberg Barclays EM LC index remains more than 8% undervalued versus USD.3

Among EM bond markets, Asia is the only region to generate a positive performance year to date1, lifted by strong gains from the Philippines, as the central bank there has slashed rates. Moreover, we know that several of the larger Asian countries, notably South Korea and China, have been more effective at dealing with COVID-19.

Visit www.abf-paif.com* for our latest insights and investment ideas for Asian fixed income.

1 Source: Bloomberg Finance L.P., as of 15 July 2020.
2 Source: Bloomberg Finance L.P., as of 30 June 2020.
3 Source: State Street Global Advisors, as of 17 July 2020.

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