The Covid-19 pandemic was closely followed by China’s real estate crisis, along with rising global inflation and tighter monetary conditions. Then there was the Ukraine war, which further exacerbated global inflationary pressures via higher energy prices. The result of all this has been significantly higher yields.
For investors, the key question now is: do current yields provide a sufficiently good risk/reward trade-off?
Historical yield perspective
It is important to note the historical significance of yields for emerging market (EM) local currency bond returns. Over the long run, yield income has been the most important driver of returns for local currency EMD, and more important than both the duration and currency component of returns. Indeed, over long run periods the starting period yield level has often been a good indicator of annual total returns. In the case of the JP Morgan GBI-EM Global Diversified Index, a widely followed EM local currency index, yield compensation has increased significantly in the past 18 months. The index yield is now 7.2%, compared to 5.7% at end-2021 and 4.2% at end-2020.1
The chart below shows that the current index yield level is comfortably above the long term average of 6.5%, and in the top quartile of yields historically. Even so, we think the asset class valuation case is understated given important compositional changes in the index over time. Firstly, in the past, relatively bigger countries (with larger index weights) were higher yielders, but now many of the bigger countries (notably China), are among the lower yielders. Secondly, the index weight of two traditionally more volatile countries, Russia and Turkey, has reduced significantly, falling from a combined 20% of the index in May 2013 to a little over 1% now.
Emerging Market Local Currency bond yield (%)
Source: Bloomberg. For illustrative purposes only. No assumptions regarding future performance should be made. June 2022. Yield is for the JP Morgan GBI-EM Global Diversified Index, Red line depicts the long run average yield.
Inflation will be key
When it comes to the outlook for EM local currency bonds, inflation is always important as it’s a key driver of domestic interest rates. However at present, the importance is magnified amid multi-decade high inflation, which is the dominant concern for monetary policymaking in both EM and developed market (DM) countries. As such, when considering the asset class outlook, we think it can be useful to consider different potential inflation scenarios for both EMs and DMs.
Alternative inflation scenarios
Firstly let’s consider the likely best and worst case inflation scenarios over a three-year horizon. The best case scenario would be of inflation peaking and then falling in both EM and DM countries – in this case, EM local currency total returns would likely be excellent as some of the huge rate hikes of the last nine months could be unwound, pushing local yields lower and supporting the duration component of returns. In addition, the currency component could also contribute as this scenario may entail more controlled monetary tightening in the US going forward.
Conversely, the likely worst case scenario for EM local currency total returns would be if inflation proved sticky in EM at quite elevated levels, while inflation fell to more ‘normal’ levels in DM. This would mean that EM yields would likely keep rising (hence a negative duration impact). At the same time, although yields may provide some carry protection, we could also expect some nominal depreciation of EM currencies.
Between these best and worst cases, there are various intermediate scenarios. For example, still an unfavourable outcome would be inflation continuing to rise in both EM and DM – in this case, returns for both would be poor as yields would just keep rising, although we’d expect EM to still outperform given their yield advantage and yields probably rising relatively more in DM. A still-good scenario for local currency EMD would be inflation peaking everywhere but falling faster in EM compared to DM, allowing past rate rises to be unwound more quickly in the former.
Our base case
In our view, based on our analysis of global inflation data, we think the positive scenario of inflation peaking and moving lower in both EM and DM, is certainly becoming more imminent. However the key uncertainty regards timing, and the longer that the rolling over of inflation is delayed, then in the interim yields could keep rising for a while longer.
The importance of good selection and timing
It is worth noting that the foregoing discussion was all at the asset class level. But this necessarily ignores significant variations across countries in terms of both the inflation/rates outlook and yields/valuations. For example, the inflation picture is notably distinct and less problematic at present in China. In most other regions both inflation and yields are elevated, but with important differences in the drivers.
From an investment perspective, we are inclined to prefer countries with attractive real yields, and where there’s little evidence of demand-driven inflation, such as high wage growth. An example of this would be Brazil, which as with other commodity exporters, is also benefitting from strengthening terms of trade and an improving current account position. On the other hand, we feel optically high-yielding countries, where a lot of inflation is also demand-driven, such as in many central European countries, warrant greater caution at the present time.
Historically elevated yields have significantly improved the valuation case for local currency EMD. We think the most decisive factor for total returns over a three-year horizon will be the outlook for inflation in both EM and DM countries. In our view, a positive scenario of inflation peaking in both is coming within sight, but the key risk factor is timing. Beyond the broader asset class level, however, there are notable country-level variations in both inflation and valuations, which can matter greatly for returns, underscoring the importance of careful selection.
- Bloomberg, as of 17 June 2022