Despite pullback, the case for EM bonds remains strong

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Investor sentiment on emerging markets has swung negative in recent weeks on concerns over tariffs, trade, global growth and a resurgent U.S. dollar.

“However, we believe the long-term case for emerging markets (EM) in bond portfolios is still strong — especially if you know where to look”, says Kathleen C. Gaffney, Director of Diversified Fixed Income, Eaton Vance.

“In fact, one of our major themes is investing away from the U.S., both in terms of the dollar, rate risk and fundamentals,” she adds.

“It’s important to remember that developed and emerging markets are at different stages in their cycles. For example, in the U.S., we have low but rising inflation as the Federal Reserve unwinds its balance sheet and gradually hikes rates. U.S. GDP growth has been slow and steady, averaging around 2% the past few years.

“In EM, the picture is quite different. Many individual countries are growing fast, and most central banks are not hiking rates. In fact, those that have been hiking have broadly been defending their currencies. Also, much of the economic growth in EM is organic, rather than being based on mergers, acquisitions and financial engineering.”

EM currently offers high but generally falling inflation, which provides opportunities away from the U.S. into a more global positioning, the prospect of investing in higher real rates and an inflation hedge.

“Anti-globalization is in the headlines, but individual countries offer the opportunity for positive momentum as they find their own way in this new global environment.

“In EM, we certainly have political risk, but that offers opportunity for improvement. The impact of politics in selection may serve as an opportunity for differentiation and return, especially as developed central banks remove liquidity.

Credit quality is higher in EM from a broad balance sheet standpoint, with generally lower leverage. Also, as more investors become comfortable with the sector, EM companies can benefit from greater access to capital. And as EM companies tap the markets for financing, they have made improvements in transparency and disclosure. These are all signs of economies and markets maturing.”

She further notes: The dollar’s role Although the U.S. dollar has rebounded, we see this as a pause within a longer-term downtrend versus global currency competitors. The dollar has enjoyed its status as the world’s reserve currency, but has borne the brunt of the slowdown in growth since the global financial crisis.

The Fed is leading the way among global central banks in unwinding quantitative easing, which may account for the dollar’s recent strength. However, other central banks in Europe, Asia and South America may not be too far behind the Fed. Therefore, rates may start to converge as other central banks catch up to the Fed.

Also, some foreign governments are reducing their appetite for U.S. Treasury bonds, and some like China are diversifying their currency reserves. This lowered demand may start weighing on the dollar again soon.

The other factor that we believe will weigh on the dollar is our view on rising U.S. inflation. Of course, inflation tends to reduce the value of a currency. The U.S. is starting fiscal stimulus with tax cuts and higher deficits at a time when labor markets and capacity are both very tight. That could fan the inflation flames, and 5-year breakeven rates are moving up as well in the U.S.

 

 

Sentiment and trade wars

We believe it’s important to take a long-term view on EM currencies and bonds, because the sector can be influenced by changes in sentiment. It is oftentimes a shift in sentiment that can provide an opportunity.

The recent EM weakness has been driven by fears over the potential impact of a rising dollar, rising rates and trade tensions. There are also concerns over political instability in individual EM countries such as Brazil, Mexico and Turkey.

However, we believe EM has some secular tailwinds, including rising population growth and improving standard of living for the middle classes, stable inflation and still-favorable monetary policy. A rising consumer class, helped by the right policy mix, can serve as an engine of growth. Further, we believe EM are in a better position now than before the financial crisis. Fundamentals have improved, more countries are reforming to increase competitiveness in the global markets, and they are less dependent on capital inflows for investment.

She concludes “ We believe it’s a mistake for bond investors to give up on EM in their portfolio due to recent price weakness driven by trade fears and a rising U.S. dollar. EM can play an important role for long-term investors who can find opportunities in individual regions, countries, sectors and companies.”

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