Bond bulls breathe easy on low inflation in emerging markets

Investors nervous about whether the bull case for emerging-market assets can weather a more hawkish US Federal Reserve can take solace in the outlook for consumer prices.

While inflation in developing economies languishes near a record low, prices are starting to tick higher in the developed world, including the US, as wage and other costs rise. This is positive for emerging bonds, with 16 of 21 markets included in the Bloomberg Barclays EM local currency government debt index offering higher yields than the US when adjusted for inflation, according to data compiled by Bloomberg.

Brazil leads the pack, with its 10-year real-denominated bonds offering inflation-adjusted yields of almost 7 per cent, followed by Russia’s ruble notes at 4.7 per cent. That compares with the real yields of 0.7 per cent on Treasury bonds due in a decade. At the other end of the spectrum is local-currency debt of Egypt and Nigeria, which have negative real yields.
 

Concern over policy normalisation by the US Fed, European Central Bank, and the Bank of Japan, has rattled the EM investment case, along with speculation the revival in developed-market inflation could start to spread. But with markets fixated on the benchmark Treasury yield’s march toward 3 per cent amid expectations over US Fed tightening, the real yield premium makes emerging-market assets stand out, according to Mitsubishi UFJ Kokusai Asset Management.

“The current level of US real yield does not pose much threat to developing currencies,” said Kiyoshi Ishigane, Tokyo-based chief strategist at MUFJ Kokusai, which oversaw the equivalent of $129 billion at the end of 2017. “It is not like the US real yield is now at 2 per cent, making it hard to justify going after emerging-market assets.”

Falling commodity prices and stable currencies have kept a lid on developing-nation inflation, which is the least diverged from that of developing markets in a decade, Danske Bank A/S analysts Vladimir Miklashevsky and Jakob Christensen said. “Carry trades and yield hunting have become attractive across many emerging markets as real rates are high,” the Danske analysts wrote. “Despite reflation beginning in advanced economies and higher oil prices, we expect the relatively low emerging market inflation rates to persist in 2018.”

The market is also in a better position for buying after losses amid last month’s global stock rout, the US yield spike and now new Fed Chair Jerome Powell’s hawkish shift. The MSCI index of emerging-market currencies declined 0.7 per cent in February, after rising 6.2 per cent in the previous three months, while the Bloomberg Barclays EM local currency government debt index completed its first monthly drop since October. The currency measure declined 0.2 per cent at 6:48 am in London on Thursday. Among the markets offering higher real yields, Brazil’s inflation rate is near the lowest since 1999, while Russia’s dropped to its lowest level in the country’s modern history in January. 

“If you are looking to invest in emerging markets using local currencies, you wouldn’t want to be facing inflation where the value of your assets continue to depreciate,” said Kota Hirayama, a senior economist for emerging markets at SMBC Nikko Securities. “So if you have got a situation where inflation is easing, leading to a stable currency and therefore eliminating currency risks, money tends to flow in for decent yields.”