Five reasons emerging markets bonds may continue to dominate
Emerging markets bonds have had a strong year. We see five guideposts investors should be across for 2024.
For 2024, we see five guideposts for emerging markets that are supportive of emerging markets bonds:
- The Fed may cut its policy rate in 2024, supporting emerging markets local currency debt.
Fed Funds are pricing in above 50% odds of a cut in March, and over 70% odds of cuts in subsequent meetings. This reduces support for the US dollar against emerging markets currencies, which will likely last through 2024. In our view, currencies are the most direct winner. We are cautious about chasing long-duration assets on the assumption that long-end rates will follow suit. We are cautious because of these factors: quantitative tightening, 6+% fiscal deficits from the US and rising ones in China, as well as the rising perceived risk of central bank holdings of US Treasuries. Meanwhile, emerging markets’ central banks have maintained higher real policy rates, and their bond markets exhibit steepness. This is a positive set-up for emerging markets bonds not just for currency strength, but for rallies even if the US duration story remains indeterminate. Finally, stronger emerging markets currencies are expected to further depress inflation, making policy and market rates higher in real terms. This boost to currencies can support declining yields, even if US yields are not favourable.
- Emerging markets debt should perform well in a “soft landing” scenario, but also in a “hard landing” scenario if it comes with stagflation.
The nature of any US recession will be an important determinant of asset price outcomes. A “soft landing”, in which rates decline but with a gentle and non-inflationary decline in demand, is an ideal scenario for emerging markets. If global demand is acceptable, rates and EM currencies should rally. As for a “hard landing”, global demand falls more sharply. There might be two outcomes from this scenario. First, the US policy rate is likely to fall more sharply, maintaining the support for emerging markets Second, if any coming recession is “stagflationary” and characterised by sticky and elevated prices for less demand-elastic commodities, emerging markets will do well too in our view. Separately, emerging markets debt markets are made up of commodity exporters. In contrast, even though emerging markets equities produce external surpluses, this is not due to them being commodity exporters. The new geopolitical configuration in which key commodity producers now including Russia, Saudi Arabia and Iran, are aligned against the key developed markets importers, which would support the odds of a “stagflation” scenario.
- There are no quick policy “fixes” in China.
Property prices are high, but they are also too integrated with Chinese wealth, production and social health to adjust without control. Targeted policies encouraging consolidation in the property sector, coupled with bank and official support for lending and debt workouts, are being implemented. Housing is also becoming central to social policy, with a one trillion yuan urban housing project that includes the conversion of under-construction units to social housing. A “whitelist” of property companies that is guiding the market as to who will operate in the future has been established. Fiscal policy has also been activated, with an additional 0.8% of GDP in spending announced. However, the bulk of the work in the property sector will depend on structural reform. Previous attempts did not get traction, thus implementation remains a risk. Moreover, the adjustment in real estate prices that is required to restore equilibrium is monumental, so a decade should be a baseline expectation for that timeline. Hence, we still see no value in Chinese local-currency government bonds. However, we did gain exposure to Chinese corporate bonds after this year’s collapse in bond prices. This was a follow-on from last year’s collapse, which we also bought and sold. We continue to view the situation as an opportunity, but one with risks.
- Commodities supply risks are contained, not eliminated.
The decline in oil prices following Hamas’ attack on Israel on October 7thgives the impression that geopolitical risks are overstated. In our view, the lack of a bullish response in oil markets reflected major and regional powers’ agreement to prevent the expansion of the conflict. This includes the US’ Sunni allies as well as Iran. If this is accurate, then the key question is how long regional escalation can be prevented. One example is uranium. Kazakhstan produces 40% of the world’s uranium, making this element subject to geopolitical risk. France’s main supplier, Niger, was one of several West African nations subjected to coups. This led to France shifting its supply of uranium to Kazakhstan, which led to uranium prices increasing 50% in the early part of this year.
- Fiscal dominance will remain a key market driver. Over-indebted economies, most of which are developed markets, will continue to drive market crises, and emerging markets bond markets will continue to weather these crises.
Developed market countries suffer from excess debt, or “fiscal dominance”. Their bond markets were the largest sufferers this year as a result. In situations of “fiscal dominance”, central banks are unable to target inflation, as government bankruptcy will constrain rate hikes. This initial condition, and the absence of any likely solutions (we note that US and Chinese fiscal deficits appear large) is an additional reason to be concerned about duration.
We think, to take full advantage of the opportunities within emerging markets debt, it is necessary to take an unconstrained active approach, to avoid having the highest weighting to indebted, poorly run nations.
The VanEck Emerging Income Opportunities Active ETF (Managed Fund) (EBND) takes an active, high conviction and benchmark agnostic approach to investing across the EM bond spectrum (the benchmark is 50% J.P. Morgan Emerging Market Bond Index Global Diversified Hedged AUD and 50% J.P. Morgan Government Bond-Emerging Market Index Global Diversified).
The fund, launched in February 2020, has outperformed the benchmark since its inception highlighting its diversification benefits. EBND has outperformed broad Australian and global bond indices too. As always, we would say, past performance is not indicative of future performance.
EBND has a targeted dividend yield of 5% p.a.* and pays income monthly.
An investment in the Fund carries risks associated with: ASX trading time differences, emerging markets bonds and currencies, bond markets generally, interest rate movements, issuer default, currency hedging, credit ratings, country and issuer concentration, liquidity, fund manager and fund operations. See the PDS for details.
* VanEck determines the amount of the dividend each month taking into account all relevant factors targeting an annual dividend yield of 5% p.a. of the capital invested at the beginning of the period. VanEck may amend this target from time to time.