Emerging markets shine for fixed income

The Saudi Aramco IPO in 2018 is expected to increase non-resident capital inflows. Saudi Aramco via Reuters

Investors seeking attractive fixed-income returns over the next five years should look beyond “safe” developed economy sovereign bonds that dominate portfolios and explore opportunities in the better-valued emerging market debt space.

Historically, adding emerging market bonds to traditional fixed-income portfolios increased returns without the cost of additional risk.

Bonds are expected to face a rough ride over the coming years. Very low starting yields and rising inflationary pressures will place a substantial drag on the developed world’s sovereign bonds. Inflation is picking up –notwithstanding that oil prices have peaked – as global growth becomes synchronised and trade picks up from its recent doldrums.

In the US, a tight labour market points to nascent wage pressures and further tightening of Federal Reserve policy. The euro zone finally seems to be shaking off the after-effects of the crisis that struck across its periphery in 2011. Japan is growing steadily. And some of the recently struggling emerging market economies have shown signs of stabilisation.

Over the longer term, price pressures will persist amid central banks’ willingness to tolerate higher inflation rates than they have done in the past, stronger wage growth underpinned by minimum wage legislation, and potential after-effects of years of effects of quantitative easing.

Bond markets have started to reflect this good economic news. Yields edged up from last summer’s lows, particularly in the wake of the US presidential election as people anticipated that Donald Trump’s policies would further spur growth. Even so, about a fifth of the JPM GBI index of leading government bonds, worth nearly US$10 trillion, still register negative yields. These very rich valuations suggest developed economy sovereign bonds will continue to struggle through the cyclical recovery.

Less frequented parts of the fixed income universe – such as emerging markets – offer investors attractive prospects, as they currently benefit from substantial spreads over developed market sovereigns. Local currency emerging market bonds currently yield 6.4 per cent while emerging market hard currency bonds offer 5.3 per cent versus 1.4 per cent for developed market bonds.

What’s more, economic fundamentals are a lot friendlier to emerging market bonds than they are to their developed counterparts.

Take inflation; over the coming five years, we expect consumer price inflation in developed economies to rise to 2.1 per cent from 0.7 per cent in 2016. By contrast, inflation is expected to moderate to 3.5 per cent in emerging economies from 3.7 per cent.

Emerging market economies are also likely to grow faster than their developed rivals. We forecast emerging market real GDP to expand by 4.5 per cent a year over the next five years against an annual growth rate of just 1.6 per cent for developed countries.

A number of emerging economies are also benefiting from domestic reforms, including a shift to market-orientated policies.

A good example is India, where the prime minister, Narendra Modi, is implementing anti-graft measures and tax simplification steps that might yet pave the way for the country to reach its ­potential.

In the Middle East, oil prices remain the most important economic driver. Their sharp fall in 2015 forced GCC countries to initiate fiscal reforms and economic diversification that should lead to economic prosperity in the region. In the meantime, fiscal consolidation along with gradual recovery in oil prices should improve their public finances. In particular, in Saudi Arabia, the Aramco IPO in 2018 is expected to increase non-resident capital inflows.

There are, of course, exceptions – Brazil, for example, is again being rocked by political corruption scandals; or Turkey, where a shift to autocratic rule might be supportive of the economy over the short term, but at a cost of long-term stability.

Overall, emerging market countries with improving fundamentals and those with more worrying prospects seem to be in balance. That’s reflected in a more mixed pace of economic reforms after a generally positive trend in recent years, according to the OECD. Yet even in light of this uncertainty, emerging market bonds offer investors an attractive risk premium.

The relatively stable economic outlook, subdued inflation and attractive starting yields are forecast to bring 8.1 per cent in annual returns for emerging market local debt and 3.3 per cent on emerging market hard currency bonds (in US dollar terms) over the next five years.

By contrast, we expect the total annual return on the JPM GBI index of developed government bonds to be about 1.7 per cent, also in dollars.

A model portfolio of 80 per cent developed world government bonds and 20 per cent equally split allocation to emerging market hard currency and local currency bonds (unhedged) will generate an annual return of 2.5 per cent over the next 5 years, which compares favourably with the 1.7 per cent expected return for developed bonds.

This is in line with past experience. During the 2003-2017 period, a similar portfolio would have outperformed developed world government bonds by 87 basis points per year while exhibiting the same level of risk.

And since the start of 2003, a combined 50 per cent emerging market hard currency and 50 per cent local currency bond portfolio would have generated an annualised return of 8.3 per cent, more than 4 percentage points in excess of the developed market index, albeit with substantially higher levels of risk.

In a nutshell, despite a difficult environment for bonds, investors can find attractive fixed income returns in the emerging market debt space.

Luca Paolini is the chief strategist at Pictet Asset Management