EM local debt (measured by JP Morgan GBI-EM Global Diversified index) showed a 5.64% return bringing the total return so far in 2019 to impressive 8.72%. The positive performance in Q2 was predictably highly non-linear, with a drawdown in May on resumed trade tension and a recovery in June as global central banks signalled monetary policy easing.
Argentina had yet another bad quarter as polls show that opposition is ahead for the October Presidential elections. Turkish assets had a positive quarter as high carry and weak currency offset increased political risk. Russian assets continued to perform well as oil prices bounced and the timing and likelihood of sanctions became more muddled after the Mueller report. The biggest contribution to the index returns, however, came from the rally in bonds across the board following the re-pricing lower of the UST curve and pricing in of multiple rate cuts. Local returns were particularly large in Chile, Brazil, Peru, Russia and Turkey.
The outlook for 3Q is uncertain given a number of significant tension points -- trade, global growth, political risks, and monetary policy. However, lower US policy rates and potential weakening of the USD against EUR and JPY is conducive to carry.
In Latin America, we find Mexico at risk on fiscal/monetary policy as well as continuing trade uncertainty (the USMCA trade agreement yet to be ratified in the US Congress). The Brazilian bonds had a spectacular rally on good prospects of the pension reform and expectations of rate cuts by the BCB.
However, after the rally, the value is with the currency rather than bonds. In Argentina, the decision of former president to run as only vice-president, eliminated the tail risk of the new Kirchner presidency and supported the market. However, the outcome of the elections remains close to even and markets will no doubt be tested during the primary elections in August. Commodity-linked currencies –CLP and COP, among others-- underperformed, and have room to catch-up in a muddle-through environment.
In EMEA, Turkey remains the key market to watch. The ruling AKP lost the re-run of Istanbul by a strong margin dealing a blow to President Erdogan. In addition, Turkey is risking US sanctions over the delivery of Russian weapons expected in July. Performance of Turkish bonds hinges on the government's ability to switch to prudent policies and avoid tensions with the US, which we think is unlikely. In South Africa, the economy remains weak and struggling SOEs are a continuing drag on fiscal resources. However, the comfortable win of the ANC in the Parliamentary elections in May consolidated the President's mandate, and SA bonds have plenty of room to catch up to global bond markets. The conclusion of the Mueller investigation reduces the urgency for the US Congress to impose additional sanctions on Russia. However, the sanction risk remains due to US-Russia tensions in geopolitical hot spots, while Russian Ruble valuations are much stretched.
Central Europe has been enjoying high growth rates and some insulation from boarder EM weakness, despite the slowdown in the Eurozone. Tight labour markets, low policy rates and domestic-demand driven growth is a recipe for higher inflation. Following the large rally in yields in sympathy with global markets, CE bonds are vulnerable to a correction. At the same time, the nascent USD weakness bodes well for CE3 currencies.
Following a period of volatility in May, APAC currencies have partially recovered and the CNY stopped depreciating. However, the potential trade war escalation after the G20, or even a fragile truce, is negative for the region highly dependent on trade flows. We see gradual depreciation of the CNY due to slower growth and capital outflows, dragging down all regional currencies.
The main risks to the outlook are stemming from both positive and negative shocks – a breakdown of trade talks or inability of the Fed to validate rate cuts priced in the market (Igor Arsenin).
Currency returns: more sensitive to economic and political shocks