Emerging markets fixed income: H2 2019 outlook

Emerging markets bonds – what's the outlook for the second half of 2019? How will dovish monetary policy impact returns and yields, and do US-China trade issues matter?

by Federico Kaune, Head of Emerging Markets Fixed Income 30 jun 2019

Emerging markets fixed income: carry environment in 2Q; global factors crucial in 2H 2019

  • Dovish Central Banks rescued 2Q returns from trade uncertainty and geopolitical risks
  • EM FI credit and rates rallied on lower UST yields, FX remained subdued due to stable USD
  • Returns in 3Q will remain highly dependent on systemic global factors: Growth, Trade and Geopolitical risk

Emerging markets fixed income (EM FI) returns remained strong in 2Q, albeit at a more subdued level than in 1Q. Sovereign and corporate credit spreads endedrelatively unchanged in the quarter after selling off in May and rallying in June as central banks in Europe and the US turned decisively dovish.

In fact, all the return in 2Q in EM credit was due to the significant rally in developed rates. Local rates, on the other hand, rallied in tandem with developed rates but EMFX remained unchanged against the USD, as a reflection of the stability in the USD versus the Euro in particular. It was only late in the quarter that USD weakened somewhat on a dovish Federal Reserve.

By the end of June, sovereign (corporate) spreads as measured by the EMBIGD1 (CEMBID2) were at similar levels that at the end of the previous quarter. Local yields (as measured by the GBIEMGD) tightened 40 bps, in spite of a further strong sell off in Argentinean rates, while EMFX remained unchanged against the USD in 2Q.

Monetary policy: dovish central banks have delivered more than expected

As May came to an end, markets started pricing in rate cuts in the US and UST yields collapsed, reflecting lower than expected growth and inflation dynamics. 

The Fed kept rates unchanged on June 19th, but issued a dovish statement and revised forecasts.Taken together, markets interpreted the statement as confirmation that the next move will be a rate cut. By the end of June, markets were pricing in 50bps of cuts with 100% probability in 3Q 2019.

The ECB left rates unchanged at its June 6th meeting, but the tone of its communiques became unequivocally dovish as the month progressed.

On June 18th ECB President Mario Draghi offered a speech that was interpreted by markets as a renewed commitment by the ECB to do "whatever it takes" to stabilize lower inflation and growth dynamics in the Euro zone.

He committed to be flexible and implement additional stimulus, including amending forward guidance, lowering rates and implementing further asset purchases in case inflation failed to strengthen.

Global monetary policy: the number of 25bps rate cuts implied in rate curves

Finally, the BOJ remained consistent in their policy aimed at keeping a very accommodative monetary stance, including keeping the yield curve control policy (nominal 10 yr. JGB yield target at 0%, and monetary policy rate at -0.1%) and QE target unchanged (at ¥80 trillion a year).

Taken together, dovish central banks turned even more dovish, generating aggressive rallies in rates and equity markets and supporting riskier asset classes in 2Q.

Global growth and inflation have dropped

Economic data showed that growth and inflation in the world continued to soften in 2Q. Purchasing Managers' Indexes (PMIs) in the developed world continue to show softer readings in Europe and a decisively lower reading in the US. PMIs in China also soften in 2Q after a fleeting recovery in March.

Citing worse global conditions for trade the International Monetary Fund lowered its global growth forecasts for 70% of the global economy in 2019 and emphasized that risks were on the downside absent a resolution of pending trade disputes.

Inflation in the US as measured by the Personal Consumption Expenditures (PCE) price index declined back to 1.5% in mid-2019 after touching 2% a year earlier. Core inflation in the Eurozone has remained stuck in a 0.8%-1.2% range for the past three years. Both central banks have failed to ignite inflation to their respective 2% targets.

PMIs in the developed world: going down together now

Lingering trade disputes still a risk for emerging markets bonds

China and the US failed to reach an agreement on their trade disputes in 2Q. Quite the opposite, trade negotiations stopped and both parties threatened to escalate the dispute. 

In early May, after a round of negotiations did not yield the expected results, the US administration imposed 25% tariffs on $200 billion worth of exports that had been subjected to a 10% tariffs previously. Furthermore the US imposed further measures to reduce technological transfer to China and included communication company Huawei in its "entity list" (blacklist) due to national security concerns. China retaliated by further closing its local cyber market to US competitors, among other measures.

This uncertainty weighed on markets in April and particularly in May. In mid-June President Trump and President Xi agreed to meet at the upcoming G20 meetings in Japan on 28-29 June, reigniting hopes that a truce on the trade war may be near, in spite of the significant differences between the involved parties.

Frustrated with what he describes as an illegal immigration crisis in the US southern border, on May 30th President Trump announced his intentions to levy an initial 5% tariff on all Mexican export to the US effective June 10th, and to further increase the tariff by 5% the first day of every month thereafter up to 25% in October 2019 absent swift and sufficient action by the Mexican government to stop the flux of illegal immigrants into the US. Mexico committed to adopt certain measures and President Trump backtracked from his threat. However, the US will reassess the situation in early September and decide whether further tariffs are warranted.

Whether the global economy starts recovering or decisively slows down depends, in good measure, on the successful de-escalation of trade disputes.

In the worst case scenario, one in which negotiations between the US and China and Mexico fail, almost $1 trillion in US imports would be subjected to 25% tariffs by end 3Q2019.

Such a scenario would likely imply further lower global growth and would bode poorly for EM even if China implements stimulus measures to counter the negative impact of tariffs.

PMI readings in China & emerging markets: down again

Emerging markets fixed income outlook: abundant idiosyncratic risks and opportunities

As we come to the end of 2Q, Argentina and Turkey are once again the main protagonists this quarter. Argentina is in the midst of a heated election campaign for the presidency in October and asset prices are reacting to announced candidacies, political coalitions and polls, all of which are generating wild gyrations in asset prices. The election is happening with the backdrop of a deep economic recession with high inflation. If the winner turns out to be a market friendly one, Argentina could be one of the best trades in EM FI in 2019; the exact opposite is, unfortunately, also true.

Turkey's situation is getting more interesting on several fronts. On the domestic political front, the governing AKP party was successful in challenging the results of the local elections in Istanbul that gave the victory to the opposition CHP party by a slim margin. New elections will take place on 23 June, which are likely to be eventful. Whoever loses will likely challenge the results, elevating the risks of social unrest.

On the external political front, President Erdogan is committed to acquiring Russian S-400 missiles in July, which will put Turkey on a collision course with the US and possibly NATO and result in sanctions under the Countering America's Adversaries Through Sanctions Act (CAATSA).

Furthermore, sanctions for alleged breaches of Iran and Venezuelan sanctions to certain financial institutions could come back to the fore. If he decides not to go ahead with the S-400s, Russia could press Turkey by complicating the situation in the Syrian border. Both issues will likely keep Turkey's asset prices volatile in 3Q.

In Ukraine, outsider candidate Zelenzky won the presidency and swiftly called for snap parliamentary elections in July in an effort to secure a working majority. Markets have reacted enthusiastically to this election outcome as they perceive President Zelensky to be market friendly.

In Brazil, a larger-than-expected pension reform is likely to be voted in congress sometime in 3Q, boding well for asset prices there. Mexico and South Africa will continue to struggle to stabilize their national energy champions (Pemex and Eskom) with credible rescue plans or risk further downgrades down the road.

In Venezuela, efforts to force a political transition failed in April. The standoff between the government and the opposition lingers while the humanitarian crisis worsens. So far, about four million Venezuelans have left their country escaping the economics and security crisis. The government is relying on the backing of Russia among others while the opposition has the backing of the US, EU and others.

2H 2019 Election Calendar

Date

Date

Presidential

Presidential

Parliamentary

Parliamentary

Local

Local

Date

Jul-19

Presidential

-

Parliamentary

Ukraine

Local

-

Date

Aug-19

Presidential

Guatelama (run-off)

Parliamentary

-

Local

-

Date

Sep-10

Presidential

-

Parliamentary

Israel

Local

-

Date

Oct-19

Presidential

Argentina, Uruguay, Bolivia, Mozambique

Parliamentary

Argentina, Uruguay, Bolivia, Mozambique, Tunisia

Local

Argentina

Date

Nov-19

Presidential

Argentina (run-off), Uruguay (run-off), Tunisia

Parliamentary

Poland

Local

-

Date

Dec-19

Presidential

Romania

Parliamentary

-

Local

-

Oil prices: between supply shocks and lower growth

After reaching a high for the year in late April, oil prices had dropped about 20% by mid-June, all on account of lower global growth expectations and in spite of several negative supply shocks from Iran, Venezuela and others. A stronger USD trend in 2Q also had an impact on commodity prices including oil. 

Most recently, higher geopolitical uncertainty helped oil prices recover almost 10% to $65bbl (Brent). Attacks on two oil tankers in the Gulf of Oman, at the entrance of the Strait of Hormuz, and other actions on smaller boats in the UEA port of Fujairah were behind the sharp increase in oil prices. OEPC is likely to keep current quotas unchanged as main oil producers -including Saudi Arabia and Russia - have an incentive (mainly fiscal) to keep oil prices above $60 on a sustainable basis. Oil at around $60-$70 per barrel in the remaining of the year will be supportive of EM oil exporters.

CB dovishness is not enough, a trade resolution is needed

EM FI asset prices rallied on the back of DM central bank announcements to ease monetary policies as required to support economic activity and lift inflation and inflation expectations going forward. Such dovishness had a very powerful positive impact on risk appetite, favoring EM assets in all its forms and is likely to provide a cushion to EM assets for the remainder of the year.

However, dovishness in DM CB policies is a necessary but not a sufficient condition to for EM economies to thrive and for EM asset prices to deliver strong returns. For EM economies to deliver higher and sustainable growth - a basic requirement for solid and sustainable returns - global trade volumes and commodity prices have to recover in a sustainable fashion. For that to happen, trade wars have to subside and global growth has to stabilize.

Absent a resolution to the ongoing trade wars, dovish monetary policies will only be able to carry the world economy so far for so long. The outcome of the meeting between President Trump and President Xi at the G20 meetings could shape the behavior of EM asset prices in 2H 2019. 

We don’t expect a resolution of the trade impasse at the G20 meeting, but a good outcome will include re-engaging in negotiations and delaying any further actions on tariffs. China insists that achieving progress on the resolution to the Huawei issues is a prerequisite for further trade talks. It is unclear at this juncture what President Trump's position may be.

EM still going but less upside after outsized YTD returns

Sovereign (Corporate) credit has delivered 11.5% (9.0%) returns; roughly half of it due to spread compression of 70bps (30bps) with the other half explained by lower UST yields. Local debt has delivered 8% returns so far this year, of which 6.5% due to an 80bps rally in local rates (as measured by the GBI EMGD).

At 345 (335) bps over UST, sovereign (corporate) spreads are not particularly compelling, but it is possible for spreads to tighten further provided that countries like Argentina and Turkey rally from their unusually high levels. Most likely sovereign (corporate) credit will deliver excess returns in proportion to the carry it generates in 3Q.

In local debt, there is ample scope for rates to rally further in an environment in which DM central banks get even softer on monetary policy. For EM FX to rally, a weaker USD against other major currencies (particularly Euro) is a necessary condition.

Duration management will continue to be of upmost importance after the recent large move in DM rates. A resolution to the trade disputes could ignite expectations of higher global growth and lead to a selloff in DM rates. An escalation of the trade disputes could dent global growth expectations further and lead to a further rally in DM rates. In the first scenario we would expect spreads to tighten, but rates to widen and EM FX to do well. In the second scenario we would expect spreads to widen, rates to rally and EM FX to be more idiosyncratic.

We now believe that DM central banks will adopt easier monetary policies in 2H as required, which will likely continue to support riskier asset classes. However, for EM asset prices to continue to deliver as they have so far in 2019, trade concerns will have to be resolved.


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