Emerging market cycles and positioning for rates, credit, and FX

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This is a sponsored article from M&G Investments.

Claudia Calich, manager of the M&G Emerging Markets Bond Fund, discusses the outlook for emerging bond markets

The current economic cycles underway in individual emerging market (EM) countries form a hugely varied landscape, providing a diversified investment universe.

Against this backdrop, a very flexible mandate is crucial to take advantage of the full opportunity set of bonds and currencies in the asset class.

Four distinct EM economic cycles

Widely different economic conditions invariably prevail in individual countries. When investing in EM bonds, correctly assessing the implications of these various economic cycles is key in determining how to build (or avoid) exposures to a country’s assets. Given these considerations, a highly flexible mandate is crucial to be able to fully exploit the range of opportunities to add value in the EM sovereign and corporate debt markets, and currency markets.

Emerging markets are generally more sensitive to economic and political factors, and investments may be less easily bought and sold. In exceptional circumstances, difficulties may be encountered when selling or collecting income from EM investments, which could cause incurred losses.

Figure 1 shows four distinct economic cycles that are typically found when analysing developing nations.

Avoiding fundamental downturns

Some countries may be in a state of ‘crisis’, for example Venezuela at the current time, while others may be ‘stabilising’ after a problematic period. In the former phase, the country’s currency is likely to come under significant pressure as the economy goes into crisis. As a result, inflation overshoots and the central bank is forced to hike interest rates to counter rising prices and capital outflows. In an environment of rising country risk, credit curve steepening leads to bond prices falling. Taking short positions in a country’s bond or foreign exchange (FX) market can be a useful strategy if either its economic outlook is particularly unfavourable, or if valuations, particularly on the FX side, appear significantly overstretched.

Picking the turning point

For stabilising countries, there will be firm evidence that indicates the economy is bottoming out. However, at this stage, inflation is still elevated and/or rising, with local real yields lacking attraction. These environments are assessed very closely with the intention of picking the turning point to add investment opportunities. On a selective basis, sovereign and corporate bond allocations can offer upside potential in these instances, while long exposure to the local currency may also be appealing.

Ecuador provides a case in point in this category. Oil production is very important for its economy and, therefore, it has benefited from the recent rise in oil prices. GDP growth was -1.5% in 2016, but is forecast to have been modestly positive in 2017, to exhibit a typical ‘bottoming out’ trend.

Real yield appeal

Encouragingly, many EM economies progress from the stabilising backdrop to an ‘improving’ stage. During these times, an economy displays healthy recovery signals, such as an appreciating currency and declining inflation expectations.

In turn, lower inflation can add compelling real yields to the investment case for the country. Monetary policy is also likely to help bond investors’ sentiment, given that, as inflation peaks, the central bank can support the economy by lowering interest rates.

Egypt is in such an improving economic cycle. Tourists are returning to the country, helping to accelerate its growth outlook, with GDP growth forecast at more than 4% in the current year and in 2019. Furthermore, high inflation – triggered by the break from a currency peg – should have peaked and M&G Investments (M&G) expect disinflation and real yields to be supportive.

Changes in currency exchange rates will affect the value of investments. As a general theme, a long duration stance is favoured when allocating to emerging economies in these cycles.

Boom times: Risks and opportunities

If an economy progresses to a boom cycle, there are a number of key risks and opportunities for EM bond investors to weigh up. In these cycles, inflation rises above the central bank’s target – a consequence of the economy overheating. In addition, the country’s currency valuation is likely to be high, and there is the prospect of interest rate rises to counter inflation and balance the economy. This background typically warrants staying short in terms of positioning on the local rate curve.

Romania currently appears in boom territory, producing a hefty 7% growth in GDP in 2017. Such an increase suggests the economy is growing above potential, with rate tightening by the National Bank of Romania already taking place in the first quarter of 2018.

The positive side in a boom scenario is that default risk is low, helping to drive spreads tighter. We are happy to seek additional value by investing in corporates that benefit from the robust economic environment while paying a spread pick-up. A corporation with output geared to the local economy can provide such potential.

Overall, M&G continue to favour a flexible approach, especially for bonds and currencies offering the best relative value. In contrast, potentially unfavourable countries or industries are avoided. We actively manage duration, credit risk, and currency positioning to achieve long-term performance as we seek to generate competitive returns in different economic and market conditions.

Data: All data from M&G as of 6 April 2018.

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This is a sponsored article from M&G Investments.

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