Outlook 2017: Secondary market headwinds remain for EM bond assets

By Christine Van Dusen

Atlanta, Dec. 30 – Trading of emerging markets bonds is expected to remain challenging in 2017, following a year that saw significant negative sentiment toward the asset class spurred by falling oil prices, political tumult across the globe and Donald Trump’s largely unexpected presidential win in the United States.

“The bursting of the commodity bubble, the enormous glut in the oil market and the Chinese growth slowdown all weighed on EM growth,” said Peter Kinsella, an analyst at Commerzbank.

Also burdening the asset class was Britain’s vote to leave the European Union, the coup attempt in Turkey, the impeachment process in Brazil, tensions related to Russia’s involvement in Ukraine and the fighting in Syria.

“The financial year has concluded with greater complexity, uncertainty and risk,” said John Owen, a portfolio specialist with NAB Asset Management. “The assets that performed well were those perceived to be safe havens, or those providing income certainty, such as global government bonds, gold, listed property and selected alternative investments.”

Still, emerging markets bonds managed to perform, with the MSCI Emerging Markets index outperforming the S&P 500 from January to October 2016, and the asset class drew a record amount of inflows. That mostly stemmed from ETF activity, driven by interest in short-term performance, a trader said.

And then, when November came and Trump was elected president in the United States, “the wheels came off the EM bus,” Kinsella said. “EM currencies depreciated, yields on hard and local currencies increased and the market priced in a more aggressive Fed.”

Indeed, the MCSI EM index fell 6.1% from Nov. 9 to Nov. 21, Owen said, and EM funds saw nearly $3 billion in net outflows.

The asset class enters 2017 “with a more nuanced setup,” Kinsella said. “EM, as a whole, should illustrate growth prints in the region of 4.6%.”

Repricing is possible

With better growth and slightly higher inflation in many EM economies, it’s likely that EM rates will reprice.

“This development is compounded by higher developed-market long end yields and dollar appreciation,” Kinsella said.

China will be a market to watch, he said. Performance in 2016 was supported by the central bank’s rate-cutting cycle, and investors increased their leverage. This, alongside decreasing deflation fears, could be “problematic,” he said.

“Investors could all go for the door at the same time,” he said. “This will inevitably lead to concerns of capital flight once again. In this respect, there are greater potential risks from the Chinese bond market than the currency.”

Turkey under pressure

Turkey, meanwhile, is likely to remain in the spotlight, a trader said. The government’s approach to interest rates is putting pressure on the currency, which could lead to issues related to creditworthiness.

Said Kinsella: “Turkish external debt is a potential risk factor in 2017.”

But Brazil, Argentina, Ukraine and Indonesia could all be good buys in the new year, according to a report from Morgan Stanley Research.

“The global hunt for yield supported EM throughout 2016, but 2017 will present new challenges,” the report said. “Core rates should continue to rise and the dollar should resume its strengthening path. And of course, the U.S. election result casts uncertainty over the future of global trade, a particularly relevant driver for EM.”

Serbia to outperform

Across the tighter-trading credits, Morgan Stanley likes Serbia and expects it to outperform.

“On the other hand, we expect Mexico and South Africa to underperform, as spreads are not wide enough to absorb the external shocks that are likely to hit EM in the coming months,” the report said.

Though Mexico has done well in managing issues related to oil prices, the sovereign still faces great difficulty following Trump’s win, a trader said.

And many EM funds are slightly overweight to Mexico, Morgan Stanley said, so there will be “very little incentive to add Mexico exposure.”

Taking a closer look at Latin America, the region is expected to outperform in terms of credit quality in 2017, said Cedric Rimaud, director of emerging markets for research firm Gimme Credit.

Returns likely to suffer

“The credit markets have rallied strongly in 2016, and the excess yield earned by holding EM corporate bonds has narrowed,” Rimaud said. “We therefore expect that the returns from the sector will be lower in 2017 than in 2016.”

Total returns for EM are likely to suffer well into the first half of 2017, the report said, as fixed income remains exposed to higher core rates, the stronger dollar and uncertainty related to trade protectionism.

“However, stronger EM fundamentals now should provide a buffer that prevents a significant sell-off like the taper tantrum in 2013,” the Morgan Stanley report said. “We also believe that once the initial adjustment to higher core yields and a stronger dollar is complete, a more constructive view on market beta will be supported by the resumption of the structural bid for EM.”

“The bursting of the commodity bubble, the enormous glut in the oil market and the Chinese growth slowdown all weighed on EM growth.” – Peter Kinsella, an analyst at Commerzbank

“The global hunt for yield supported EM throughout 2016, but 2017 will present new challenges.” – A Morgan Stanley Research report

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