Emerging-market optimism dashed by Fed as currencies, bonds sink

An April rout in emerging-market (EM) bonds and currencies has some former bulls turning negative on the outlook for the asset class.

Developing-nation sovereign bonds slid by the most in seven months, while a gauge of currencies fell to the lowest since November as fears over higher-for-longer US interest rates and worsening geopolitical tensions sapped risk appetite last month. 

While assets have staged a rebound in early May, many money managers are rethinking their optimism after last month’s sell-off. Societe General sees the risk of stagflation in the US dealing out further punishment to EM currencies and shorter-maturity bonds. Mackay Shields says the strengthening US dollar and repricing of the Federal Reserve rate outlook are dashing hopes for further gains this year.

“This year has disappointed the expectations early on regarding the claim of victory over global inflation,” said Phoenix Kalen, head of emerging-market research at Societe Generale in London. “Inflation has proven to be a much tougher adversary for central banks to tackle, so optimism over the EM rates story for this year has really crashed and burned.”

An MSCI index of developing-nation currencies slipped 0.6 per cent in April, while a Bloomberg gauge of EM dollar bonds sank 2 per cent and one of local-currency debt slid 1.3 per cent. All three gauges had rallied at the end of last year amid optimism the Fed would start cutting interest rates in 2024.

Kalen said SocGen was bullish at the start of the year but turned bearish on EM currencies in early February and more negative on developing-nation rates in April. One of the reasons for the switch was concern the prolonged period of higher interest rates will cause stagflation in the US, she said.

“We are expecting some version of stagflation to materialise, with attendant adverse impact on EM currencies and short-dated EM rates,” Kalen said.

The impact will be most heavily felt in markets with a high sensitivity to US rates such as Turkey, Hungary and Latin America, while Asia may be less affected, she said.

Global money manager Mackay Shields said the earlier optimism over a rally in EM local debt was dashed by headwinds caused by falling currencies and worsening rate differentials.

“Emerging-market FX weakening versus the dollar has a direct impact on performance mathematically but it also translates into the lack of inflows coming to the asset class,” said Valentina Chen, co-head of emerging-market debt in London. “US rate repricing narrows the real rate differentials between EM and the US. This makes the asset class less attractive from a carry perspective.”

Not everything is doom and gloom though. Economic growth in a number of EMs has been resilient despite high real yields, especially in Latin America, and there are a few countries that present investment opportunities, such as India and Turkey, Chen said.

Mackay Shields is “staying nimble” on EM currencies as they often tend to overshoot but isn’t about to fight against the appreciating US dollar, she said.

Los Angeles-based Payden & Rygel is another money manager that has turned more negative on EM assets as the year has progressed.

A key driver of the disappointment was the fact emerging-market policymakers were unable to go ahead with as many rate cuts as the market expected based on local inflation and growth dynamics, said Alexander King, senior vice-president at the fund manager. The fundamentals of many EM nations still look pretty good, but “it’s just so dominated by the Fed”, he said.

“We were feeling more bullish because it just felt like the tone was better,” King said. “Unfortunately our view has worsened.” BLOOMBERG