Emerging Markets Hard Currency Debt stands out in 2020
An article by Dr. Christian Wildmann
Head of Emerging Markets, Union Investment
In 2019 euro area peripheral government bonds and emerging markets sovereign debt were the main sources of performance for fixed-income investments. The key driver of the strong returns last year was the sudden change in the Federal Reserve’s (Fed) monetary policy stance, which mainly benefitted spread products and weighed on safe havens.
As last year, in 2020 it will be most important again to look at the relative attractiveness between asset classes, and in this perspective, emerging markets (EM) hard currency debt stands out.
This is confirmed by our five-year return forecasts: EM have the highest expected returns of the major fixed-income asset classes, at an acceptable level of volatility.
This setting should continue to produce very good inflows into EM sovereign debt, and it is creating a very forgiving market environment for the issuers. Romania is a good example of this: The country is running a primary deficit of close to 2 percent of gross domestic product, its public debt is currently on an explosive trajectory and the country may be downgraded to a non-investment grade rating later this year. And yet, its euro-denominated government bonds trade at a yield of only 2.5 percent, and market access is not an issue. The country would be in an entirely different situation, if Bund yields were not negative and if Italian government bonds would not barely yield 1 percent.
Local markets: Currency Play
With respect to local markets, last year was definitely a year to invest in local rates. Following the sell-off in 2018, the markets were priced very attractively, and EM central banks followed the Fed in cutting their policy rates. At the start of 2019, South African government bonds were yielding 8.8 percent on average, Turkey was offering 16.7 percent yields and Indonesia’s bonds stood at a yield of 8.0 percent. This opportunity has now largely vanished: Domestic rates of return have declined to 6.1 percent in South Africa, 11.7 percent in Turkey and 7.1 percent in Indonesia. The average yield of the JPMorgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified has fallen from 6.4 percent to 5.2 percent over the course of the past twelve months. So, this year may be more suitable for a currency play than a rates play in local markets, since the Fed may end its rate cutting cycle before the US elections and emerging markets central banks will also be cutting rates less aggressively.
As geopolitical risks recede and the global economy stabilises, we are already seeing signs of emerging markets currency strength, particularly in Asia, where the Chinese Renminbi and the Indonesian Rupiah have appreciated quite a bit in early 2020. While low-yielding currencies may still struggle to appreciate against the US-Dollar, which remains to be a high-yielding asset currency (by developed market standards), the Euro has definitely become a funding currency with the European Central Bank (ECB) on a permanent hold at a policy rate of -0.5 percent.
This renders currencies in Central and Eastern Europe (CEE) particularly attractive. Our currency valuation models show good scope for appreciation of the CEE currencies, which benefit from relatively high cyclically-adjusted current account balances and a comparably low purchasing power. We have a special focus on Russia, Turkey and Ukraine.
But there is also a specific risk involved as a conflict is brewing between populist administrations in Central and Eastern Europe and the founding member states of the European Union (EU), as evidenced by France’s opposition to North Macedonia’s accession plan. Western European countries may want to use the “power of the purse” in the upcoming negotiations on the EU’s multi-year budget to exert pressure on CEE.
Emerging Europe: Turkey and Ukraine attractive
currency positions in Turkey already delivered a return of 22.9 percent in 2019 (GBI-EM Diversified: 13.9 percent), unhedged in euros, and hard currency debt of Turkey and Ukraine still appear attractive in 2020, at spreads of close to 400 basis points. But sovereign bonds of promising Central European core countries like Poland, the Czech Republic or Hungary also offer attractive yield pickups from a risk-return perspective.
On a global level, we also like hard currency bonds issued by Indonesia (spread of close to 150 basis points), Nigeria (500 basis points), Ivory Coast (380 basis points) and Egypt (450 basis points).
When investing in emerging markets, country-specific risks and challenges are involved, which need to be watched closely and make an active investment strategy indispensable.
As at 22 January 2020