| EM fixed income - Still enjoying its defensive status |
| 18.11.11 07:32 | |
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The past couple months of heightened risk aversion have generally been shrugged off by EM local government bond yields, even though the risk aversion has involved wider signs of dislocation across European government bond markets, high volatility in EM currencies, and (compared with earlier this year) a dearth of portfolio inflows to EM local bond funds. For a discussion of the latter, please see our most recent Emerging Market Flows Snapshot, 11 November 2011; our view is that these flows will not resume soon, given likely continued EM FX volatility that would hold back foreign investors. That said, there are still good pockets of value in EM local bonds, and while we have not seen a backup in EM yields to create immediately attractive opportunities, in some parts of EM, nominal yields are still high, curves steep (a measure of ample risk premia) and public sector debt fundamentals attractive. We view the lack of reaction from EM yields as a positive - a sign that in most cases, the need for foreign investor savings to prop up local bond markets is modest and that EM fixed income generally retains the defensive status it has enjoyed since the 2008 financial crisis. In terms of EM local bond asset allocation, we recommend being underweight EEMEA, overweight Asia and market weight LatAm. For investors with the flexibility to do so, we recommend having these positions generally FX hedged for the next few months, as we still see continued high levels of uncertainty out of Europe, which could keep pushing up FX spot volatility. Our baseline view has been that a large number of the major EM local bond markets still look attractive, and this has not altered hugely with the developments in the past couple of months. We think it is still the case that in a risk scenario of the global outlook darkening further, EM policymakers can react with accommodative monetary policy, which would provide an anchor for yields. Of course, a repeat of the scale of monetary easing that occurred around the time of the 2008 financial crisis is unlikely (policy rates and yields are lower than at that point) but the anchor still holds, especially as in some cases, fiscal policy is in tightening mode, anyway. Heightened risk aversion could, of course. lead to steeper EM yield curves (as investors become concerned about lower growth, higher fiscal deficits, and pressures on public debt levels). But this risk is probably compensated to some degree by the steepness in some EM curves. Most EM curves are higher and steeper than the major non-euro area government bond curves. Yet measures of local fixed income riskiness are not especially high in EM, either (in the chart, gauged by the product of public sector debt to GDP ratio and share of local government debt in foreign hands). Foreign holdings of EM local bonds have increased significantly in the past three years; as a result, EM has naturally become more dependent on the continued sponsorship of foreign investors to roll over maturing paper and to fund ongoing deficit needs. Naturally, this makes the markets a bit more vulnerable to position squeezes of foreign holdings (especially as these holdings are largely, by our assessment, FX unhedged), which can push up yields. However, the percentage holdings, while having risen, are still not approaching the levels in developed markets. Moreover, the rise reflects the fact that EM markets are small, and if there is secular shift from developed to EM bond markets, these percentage holdings could rise quickly, anyway. The surprise, perhaps, is that with the appetite for EM local bonds in the past two years and the problems in some developed markets, the percentage shares are not a lot higher. source: BarCap |
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