Quarterly Outlook: EM-Bonds
The US and European central banks have both lowered their policy rate but the ECB went a little further and has started purchasing bonds again
Central banks have put up their umbrellas
At the beginning of Q3 we wrote that the clouds have become more grey but that the central banks had their umbrellas ready. During Q3 the central banks have put up their umbrellas
The US and European central banks have both lowered their policy rate but the ECB went a little further and has started purchasing bonds again. This was very supportive for EM bonds. We forecast that this will also be the case for the remainder of the year albeit on a smaller scale as most of the support from the US and Europe has been discounted.
Global growth is suffering under the uncertainty created by President Trump’s trade war between USA and China. The German growth in particular is weak, which spills over into the Eastern European countries. The Chinese economy is also displaying signs of weakness. Prospects for the US economy are not fantastic but probably a little better than for the two other economies.
This represents a rather unfavourable background for emerging markets but as a result of the monetary policy easing in USA, China and the euro area there is also room for monetary easing in emerging markets, which EM central banks have already implemented to a great extent in Q3. We will not list every country but India, Brazil, Indonesia, Turkey and Mexico are examples.
It is doubtful whether further monetary easing is capable of supporting economic growth already this year but we forecast that the positive effect will be visible already early in the new year. Lower EM policy rates may risk affecting EM currencies adversely or at least making the currencies more vulnerable but as a result of the extremely low interest rates in Europe and partly in USA the risk is less imminent. In contrast an escalation of the trade war will hit the EM currencies.
EM bonds issued in external currency, mainly USD and EUR, are more exposed to the positive impact of lower interest rates in USA and Europe than the risk of a trade war. If the trade war escalates it is likely to hit albeit on a smaller scale than on EM currencies. With approx 3.5 percentage points the yield spread to US Treasuries offers some protection. Therefore we are positive on EM bonds issued in external currency in the period ahead.
In the last quarter of the year the presidential and parliamentary elections in Argentina will be of significant importance. Opposition candidate Alberto Fernandez won the primary election in Q3, which sent the country’s government bond prices plummeting and put the peso under great pressure. Mr Fernandez may well take over after the reform-hungry President Macri. Despite an agreement with the IMF the country is currently close to yet a sovereign default because it is not able to balance the government finances given the current interest rates. The prices of the country’s bonds have therefore discounted a sovereign default, restructuring or roll-over and consequently the worst price drops may well be behind us.
In Brazil politicians are very close to finally adopting the long-awaited pension reform and have already embarked on other reforms. This is very positive and will in time lead to increased economic growth in Brazil. In the short term the pension reform has meant reduced country risk, which in combination with lower inflation has made it possible for the central bank to cut the interest rate significantly, which in itself will affect economic growth.
Ukraine is another bright spot where the new President Zalensky has already started the reform efforts. This has already been rewarded with credit rating upgrades by S&P and Fitch.
All in all we are positive on EM bonds, in part because the central banks have put up their umbrellas.