NN IP believes EM debt will perform well despite rising US rates and a stronger dollar

Marcelo Assalin

Despite quite some volatility, 2016 proved to be a very strong year for emerging market debt (EMD). Hard currency bonds, local currency bonds and EM corporate debt all realized returns of 10% or more. NN Investment Partners believes that – despite some headwinds in the near term – emerging markets can continue to do well in an environment characterized by rising US bond yields and a stronger US dollar.

The main reasons for this belief are that the economic growth outlook in emerging markets is improving, while the external balances of EM countries have improved considerably. Real interest rates are high, inflation is on a declining trend and currencies are undervalued. In addition, higher commodity prices also support EM growth.

Marcelo Assalin, Head of Emerging Market Debt at NN Investment Partners, comments: “US bond yields moved sharply higher after the outcome of the US election. Investors anticipate significant fiscal expansion in the US under the new administration, which should result in higher inflation and higher interest rates in the medium term. While rising US interest rates normally create headwinds for EMD, so far it has been extremely resilient. We believe such a strong resilience is related to the fact that the fundamental backdrop in EM has improved over the past years. Economic growth numbers started to exceed expectations in 2016 and momentum accelerated going into year-end. Improving growth dynamics in developed economies and stable-to-rising commodity prices should provide a tailwind for EM countries in 2017.”

Assalin adds: “In addition, another important fundamental development in EM has been the remarkable reduction in external refinancing needs, enabled by a sharp reduction in current account deficits that took place in most EM countries. Moreover, inflation in EM is declining after a few years of being above target levels, while real interest rates are still high. Importantly, EM currencies remain significantly below their long-term averages. All this creates a very positive combination of supportive factors for EM countries.

We believe in a further improvement in the EM growth outlook, driven by the recovery in commodity prices. In addition, some major EM economies will be coming out of recession. Russia and Brazil, which have been in recession for the past two years, will very likely start printing positive growth numbers in 2017. And Chinese growth will remain well-supported by monetary and fiscal policies. What’s more, the positive growth differential between emerging and developed economies is expected to start widening again.”

“If we look at the EM bond universe, the yield is close to 7% in local bond space and in the hard currency segment the yield is close to 6%”, according to Assalin. “Given the improvement in fundamentals, these valuations in emerging markets are attractive, especially compared to the 0.3% yield on German Bunds. This yield differential remains a crucial driver behind flows.”

Assalin continues: “When talking about our outlook for emerging markets, we obviously cannot ignore the change in US policy following the election of Donald Trump. The main risk for investors and financial markets going forward is a confrontational Trump, who clashes with Republicans in Congress on fiscal and trade issues. In case Trump introduces trade tariffs on goods imported from emerging markets, this would undoubtedly have negative effects on EM exports, especially of those countries with strong trade links with the US. We do however believe Trump will focus on his growth agenda, which will also benefit emerging markets.”

With regard to returns, Assalin expects another positive year for EMD. Assalin: “Our forecast for US 10-year yields is a rise to close to 3% at the end of 2017. This does not mean that EMD spreads should widen. Historically, most of the times when US interest rates moved higher because of an improving growth outlook, EMD spreads tightened. So while US 10-year rates may move up to around 3%, we see spreads in Hard Currency space, both sovereigns and corporates, tightening towards 300 basis points. This could result in a total return of the asset class between 5% and 6%.”

“Our forecast for local bonds is similar. We expect the return of the GBI-EM index to be between 4% and 6%. Most of this will be driven by the carry of the asset class which has a yield of close to 7%. In an environment where the dollar is likely to appreciate because of stronger US growth, the contribution from EM currencies is expected to be slightly negative.”