Emerging Markets: Beyond the Dollar

Mid Week Bond Update

Emerging Markets: Beyond the Dollar

The dollar pulled back somewhat from its mid-April climb, but the narrative of a rising greenback has gripped the imagination...


... of the markets. Many fear the rising dollar will badly erode the price of emerging-market raw material exports, and therefore expose supposedly over-leveraged EM countries to the ravages of default, buyouts by the IMF and its brethren, and years of externally-imposed austerity.

Interest rates on the local-currency sovereign debt of EM countries have certainly reacted according to the script, with knee-jerk EM redemptions driving bond prices downward, and therefore pulling yields up.

 

Yields on Emerging-Market Local-Currency Sovereign Debt (5-year), 5/22/2018

Source: Bloomberg, May 18, 2018 Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

The challenge for investors is that the characterization of EM economies may be outdated. U.S. dollar exposure on emerging economies is much reduced, as a larger percentage of local sovereign debt is denominated in home-country currencies – leaving the currency exposure with outside investors instead of local central banks. Several major economies, including India, have moved dramatically up the value chain, exporting services much more than goods.

Clearly there’s trouble in some economies, including Argentina, Turkey, Russia and Brazil.  But those challenges are country-specific, and in at least one case (Argentina) appears to have met its match in the currency markets.

Investors who do their homework focus on opportunities as well as the risk; when a central bank takes a stand and has the firepower to make it stick, a 20% yield on a 5-year government bond could very well be an opportunity for incremental return rather than merely an indicator of risk.
 

On the Rise: U.S. 2-year Treasury Yields

The so-called “war on savers” may be winding down, as rising yields on the shorter end of the curve make lower-risk bonds more attractive.

Specifically, 2-year Treasuries may present U.S. dollar investors with an opportunity for return in ranges competitive with inflation rates.  As of May 22, 2-year yields were at 2.5847%, has begun to overtake the Consumer Price Index ex food and energy, raising the possibility of real, i.e., inflation-adjusted interest rates rising above 0.0% for the first time in years.

 

U.S. Treasury Yields, 5/22/2017 - 5/22/2018

Source: Bloomberg, May 22, 2018 Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

On the Slide: Italy’s sovereign bonds

For months after the inconclusive Italian election in March of this year, financial markets reacted calmly to the ensuing uncertainty.  But when a coalition agreement was inked between the 5 Star Movement and the League, markets finally saw moments of discomfort; Italy’s 5-year bond yields jumped to 1.199%, more than doubling from a post-election low of 0.472% on March 29th.

 

Italy 5-year Governments (BTP), 12/30/2017 - 5/22/2018

Source: Bloomberg, May 22, 2018 Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

The downdraft in 5-year sovereign debt was due to the contents of the coalition agreement, an uncomfortable juxtaposition of budget-busting increases in subsidies to both people and businesses, as well as a broad, if unspecific, anti-EU tone.

Of course, there’s much work to be done before the coalition takes power, and proposals may evolve.  Yet even after a government is put in place, it’s far from clear that the coalition would be able to hold.

 


All data:  Source: Bloomberg, on their respective dates.

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