The Fed’s Wind Down Favors EM Bond Duration?

By Eric Fine
Portfolio Manager, Emerging Markets Fixed Income

Emerging markets bonds continue to outperform developed markets bonds, and could continue to benefit from positive secular tailwinds in the long run.

In May, the VanEck Emerging Markets Bond Fund returned -0.95%, compared to -1.07% for its benchmark (the 50% J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified and 50% J.P. Morgan Emerging Markets Bond Index (EMBI)). Year to date, the Fund has returned 3.18%, in line with its benchmark, which has returned 3.12%. We are increasing duration in USD-denominated bonds and reducing exposure to Asian EMFX. We continue to have very low high-beta EMFX exposure (no South Africa or Mexico, for example) with the exception of Brazil, which appears very attractive following recent weakness. The Fund ended May with carry of 6%, duration of 5.6 and roughly 50% in local currency. View here for a PDF version of this blog.

^† Returns less than one year are not annualized.

Expenses: Class A: Gross 2.55%, Net 1.27%; Class I: Gross 2.51%, Net 0.97%; Class Y: Gross 2.91%, Net 1.02%. Expenses are capped contractually until 05/01/24 at 1.25% for Class A, 0.95% for Class I, 1.00% for Class Y. Caps excluding acquired fund fees and expenses, interest, trading, dividends, and interest payments of securities sold short, taxes, and extraordinary expenses.

Expenses are capped contractually until 05/01/24 at 1.25% for Class A, 0.95% for Class I, 1.00% for Class Y. Caps excluding acquired fund fees and expenses, interest, trading, dividends, and interest payments of securities sold short, taxes, and extraordinary expenses.

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Duration a winner? Either the Fed has a few more hikes in it, or it is done hiking; either way that boosts the attractiveness of duration, we think. It could also challenge some EM currencies (EMFX). The Fed decided to “skip” a rate hike in June and indicated that it might hike further this year with two additional hikes projected in its dot plot, while the market is currently pricing in only one additional hike in this cycle. We believe these conditions favor duration. We’d also note that although the 10-year U.S. Treasury yield might be trading in a range, the 30-year yield might be declining.

China uncertainty helps duration, but hurts EMFX. The latest theme to gather steam is Chinese currency weakness. This exports deflation, adding to duration’s attractiveness. In addition, it challenges other EMFX, particularly those in Asia. China’s inflows and interest rate differentials with the U.S. have disappointed recently. This has led to Chinese renminbi (CNY) weakness, as well as recent EM currency weakness. The chart below shows CNY versus EMFX and some high beta currencies like the South African rand (ZAR), Mexican peso (MXN), and Malaysian ringgit (MYR).

CNY Driving EMFX Weaker, and Will ZAR Lead MXN Weaker?

Source: VanEck Research; Bloomberg As of June 2, 2023. Past performance is no guarantee of future results.

Our EM bonds over DM bonds thesis is intact. US recession risk that can’t be met with stimulus vs. China growth risks that can be met with stimulus are becoming the big wheels turning in coming quarters. This will reinforce our view that over the longer run, many EM local-currency bonds remain subject to positive secular tailwinds. Emerging markets have been well ahead of developed markets on the inflation fight, and now have more tools at its disposal. If the U.S. enters recession, what will be the policy response? Monetary easing? Fiscal stimulus? It is next to impossible for us to see the political conditions for the latter, which means monetary policy will again need to do the heavy lifting. This implies dollar weakness to us. Whether this manifests by the Fed having to ease rates policy and increase its balance sheet first, and then the dollar starts to suffer, or whether the dollar starts to discount this earlier will be a big part of the market story in the coming quarters.

EM Inflation Continues to Impress

Inflation in DM and EM Regions (% year-on-year)

DM – US, UK, Germany, Canada, Japan, Australia.

Headline Inflation in Selected EM and DM (% year-on-year)

Source: VanEck Research; Bloomberg LP. Past performance is no guarantee of future results.

In May, the Fund returned -0.95%, compared to -1.02% for its benchmark; YTD, the Fund has returned 3.18%, in line with its benchmark which has returned 3.12%. Winners were South Africa (not owning it), Peru local currency, and Sri Lanka local currency. Zambia local currency, Turkey hard currency, and Mexico (not owning it) were the key detractors.

We are increasing duration in USD-denominated bonds and reducing exposure to Asian EMFX. We continue to have very low high-beta EMFX exposure (no exposure to South Africa or Mexico, for example) with the exception of Brazil, which appears very attractive following its weakness. The Fund ended May with carry of 6%, duration of 5.6 and roughly 50% in local currency. Our biggest exposures are to Indonesia, Malaysia and Brazil.

Exposure Types and Significant Changes

The changes to the Fund’s top positions are summarized below. Our largest positions in May were Indonesia, Malaysia, Brazil, Thailand and Peru:

• We increased our local currency exposure in Brazil and hard currency sovereign exposure in Hungary and Serbia. Brazil’s spectacular disinflation progress and a less bad outlook for the new fiscal framework improve the outlook for the policy rate cuts, strengthening the policy and economic text scores for the country. Hungary could benefit from more encouraging EU funding headlines, but the recent measures to support domestic demand for local bonds could reduce their attractiveness for non-resident investors, making sovereign bond exposure a better option. Serbia’s sovereign bond is denominated in euro, and it might benefit from the improvements in relative growth expectations for Europe, as well as from the longer tightening cycle vs. the U.S. In terms of our investment process, this improved the technical test score for the country.
• We also increased hard currency sovereign exposure in Egypt and Ghana (though only to their minimum limit levels) and local currency exposure in Sri Lanka. The common theme for all countries is the improving policy test score. Sri Lanka and Ghana are seeing further progress in debt restructuring, while the Egyptian government introduced new taxes and raised certain fees to boost government revenue.
• Finally, we increased our local currency exposure in Uruguay and Colombia, hard currency quasi-sovereign exposure in Colombia, hard currency sovereign exposure in Oman, and hard currency corporate exposure in Hong Kong. The Hong Kong option might be a less risky way with a better policy test score to get exposure to “the China complex” with fewer concerns about China’s soft growth patch. As regards other regional considerations, Oman is less of a proxy for U.S. Treasuries than Saudi Arabia (=a better technical test score). In Colombia, we liked a combination of better valuations and a significant current account improvements (=stronger technical and economic test scores). Better valuations also drove our decision process in Uruguay, especially against the backdrop of the central bank’s more cautious stance on additional policy easing.
• We reduced our local currency exposure in Thailand, South Korea, and Chile. We were motivated by negative spillovers from China’s soft growth patch – in terms of regional demand for China’s exports, the impact on commodity prices, and currency correlations with the weaker renminbi. In terms of our investment process, this worsened these countries technical test scores.
• We also reduced our local currency exposure in Poland and Israel. Poland’s new round of political bickering with the EU and the rising tensions in Ukraine worsened the country’s policy test score. The worsening policy test score also played a big role in Israel, where domestic political noise might start affecting capital inflows, including the tech sector.
• Finally, we reduced our local currency exposure in South Africa, as well as hard currency sovereign exposure in South Africa and Mexico. South Africa’s growth concerns are intensifying on the back of electricity blackouts, and this in turn can affect fiscal and debt sustainability targets, worsening the economic and policy test scores. In Mexico, we were alarmed by negative headlines about the state-owned giant PEMEX, including a less reassuring message from the management about government support.

Originally published by VanEck on June 16, 2023.

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