EMs from (ugly) duckling to darling

Mid-Week Bond Update

EMs from (ugly) duckling to darling

Traditionally riskier parts of the bond universe, such Emerging Markets (EM) and High Yield, rallied over the past five trading days as geopolitical concerns eased, the aftermath of the recent US floods started to settle and as Europe and China continued to post positive data. EMs extended their year-to-date gains as local currencies gained and the asset class’ volatility continued to fall, just the opposite...

of what was happening a decade ago (see chart below). The EM rally was also supported by positive Chinese data: the world’s second-largest economy said inflation rose by 1.8% in August, above estimates of 1.6%, while imports gained 14.4% also in August, above forecasts of 11.7% - signaling strong internal consumption growth. Better fundamentals, including lower inflation, helped Brazil’s central bank cut interest rates by 100 basis points to 8.25% to ignite growth, boosting sovereign bonds but dragging the real 0.8% lower over the past five trading days.

The Bank of Canada raised rates by 25 basis points to 1%, another sign that global growth is improving. Overall economic optimism lifted developed market sovereign yields, with the benchmark 10-year US Treasury yield reaching 2.18%, after touching a post-US election low of 2.03% last week. Market-implied chances that the US Federal Reserve (Fed) will hike rates at its December meeting jumped to 46%, from 32% only last week. Investors’ economic worries also abated after US president Trump removed the country’s debt limit, easing pressure on public finances. Inflation expectations rose in both Europe and the US – where they reached the highest level since June.



EMs: This year’s darling? EMs extended their year-to-date gains, to 16% when EM local bonds have been translated into US dollars, and to 7.9% when kept in their own currency. The difference is the EM currency rally seen this year, as shown on the chart. The asset class gains are also underpinned by falling volatility, given the improved fundamentals. As shown last week, EMs are becoming less correlated to US dollar moves, making the asset class less vulnerable to a potential rise in US interest rates. This resilience is also supported by investors keen to pick up carry and also lured by better data. Brazil’s 10-year sovereign bonds, for instance, yield 9.8%, and Russia’s, 7.5%, well above the 2.18% offered by the equivalent US Treasury note. China’s sustained growth is also helping the positive EM momentum: apart from August’s positive trade data, the leading EM country removed its reserve requirements for certain foreign exchange trading, signalling lower concern about capital outflows. The yuan has gained 1.8% against the dollar over the past month – and what is good for China, tends to be good for EMs.


From ugly duckling to darling: EM currencies and volatility swap direction over the past decade

Emerging Markets

Source: Bloomberg 13 September 2017. The index used is the J.P. Morgan GBI-EM Global Diversified Composite Unhedged USD Index, while volatility has been measured by 1-year rolling standard deviation. RHS is Right Hand side. Past performance is no guarantee of future results. Please find definitions in the disclaimer.


Uruguay – investors queue: Investors’ demand for EM debt was exemplified by the recent Uruguay sovereign offer, which saw demand triple its US$ 1.1 bn offering for a 10-year issue yielding 8.6%. EMs have issued US$1.2 trillion worth of debt so far this year, matching last year’s mark over a comparable period, and topping a steady increase relative to one decade ago, when $375 bn was raised also over the same period. Uruguay’s economy grew at 4.3% in the first quarter (latest data available), the fastest pace since 2013. Inflation has fallen to 5.45%, down from 11% last year.



Bunds – the end of the affair? German sovereign bonds fell 0.7% over the past five trading days, extending their year-to-date negative return to 1% - heightening their status as the only major European sovereign in the red. The German economy grew at 0.6% in the second quarter, ahead of France’s 0.5% growth or Italy’s 0.4%, while inflation is running at an annualised 1.8%. Bunds, however, have rallied 7% over the past three years, largely supported by the European Central Bank’s bond-buying programme, aimed at reigniting the region’s ailing growth. Now that Europe’s fortunes seem to be reversing, investors are beginning to speculate that the ECB may start tapering its stimulus soon, which could hurt bunds. End of an affair?


Bunds fall as European, German economies recover 

German Sovereign Index

Source: Bloomberg as of 13 September 2017. GDP is Gross Domestic Product; EU is European Union; RHS is Right Hand Side. Past performance is no guarantee of future results. Please find definitions in the disclaimer.


Britain – winter is coming: Britain’s sovereign bonds, or gilts, dropped 1.8% over the past five trading days – the worst performance among major European nations. UK inflation rose to an annualised rate of 2.9% in August, above expectations of 2.8%, largely driven by higher shoe and clothing prices just as consumers hit the shops to get ready for the winter season. Some observers blame the drop in the pound, which retailers are beginning to pass onto customers as their imports become more expensive. The bad inflation news, however, lifted sterling by 1.3% against the US dollar on expectations that interest rates could be rising soon. Britons feel the chill wind.


Source for all data: Bloomberg and Barclays Capital as of 13 Sept. 2017, unless indicated.


IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.