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Bonds
Peter Becker
- Global ownership of EM debt now stands at its lowest point in close to a decade
- Given the low starting point, we could see large potential inflows when they resume. This may happen when the Fed stops raising rates
- Markets with attractive real policy rates and strong external balances should be the beneficiary of these inflows
Global ownership of EM bonds stands at its lowest point in close to a decade
The global environment led to sharp outflows from EM debt markets in 2022. The rise in US interest rates (and increase in EM inflation), combined with the increase in general risk premium, reduced the relative attractiveness of EM debt for global investors, while higher US rates has directly raised the cost of financing for EM dollar debt issuers. Net global portfolio outflows from EM came to just under US$100bn in the first 11 months of the year.
Net global portfolio flows into EM debt
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Past results are not a guarantee of future results.
As at 30 November 2022. Source: Deutsche Bank
As a result, global ownership of EM debt now stands at its lowest point in close to a decade. The chart below shows the non-resident holding of EM local currency bonds. Global ownership of Chinese local bonds has increased significantly over this period, but this has partly been reduced in 2022. Excluding China, holdings are seven percentage points lower than the average and eight percentage points lower than the pandemic. There are only a few markets where non-resident holdings of EM local bonds (as a percentage of market cap) are above the median from the last decade, and with many – including Indonesia, Mexico and South Africa – where these holdings are at their lows.
Non-resident holdings of EM local currency bonds
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Past results are not a guarantee of future results.
As at 31 October 2022. Source: Deutsche Bank
Countries with strong fundamentals should attract inflows when they pick up
Given the low starting point, we could see large potential inflows when they resume, which may be when the Fed stops raising rates or even slows down. After a year of aggressive interest rate increases, we expect more hikes in 2023, but we think the next several months will bring a less dramatic policy environment. EM countries likely to attract these early inflows are likely to be those with attractive real policy rates and strong external balances.
Real policy rates are generally higher in Latin American countries such as Brazil and Mexico as they have hiked interest rates early, helping to contain inflation. Latin American inflation now seems close to its peak, helped not only by the lagged impact of monetary tightening, but also softer energy inflation, along with weak growth. Asian inflation, however, continues to pick up, albeit slowly, on the back of delayed market reopening combined with removal of fuel subsidies in certain economies. The picture is more mixed in the Central and Eastern Europe, Middle East and Africa (CEEMEA) region with inflation likely to have peaked in some countries, such as South Africa (although core inflation has recently started to reaccelerate) but remaining high in Eastern Europe.
The outlook for external balances is quite mixed. The combination of a rise in US interest rates and general risk premia has led to a sharp increase in the cost of financing for EM dollar debt issuers, with some countries effectively shut out of primary markets and sovereign debt restructurings reaching record levels over the past couple of years. However, this has generally taken place within frontier type markets.
It is a completely different story for some of the more developed EM countries, many of which are now less reliant on foreign borrowing than in previous periods of volatility. These countries have lengthened the maturity of their issuance, and the foreign ownership of local currency bonds has broadly decreased, which should result in a lower risk of sudden reversal in capital flows. Many of these countries have strong enough external balance sheets and access to capital to withstand the volatility and have built large foreign exchange reserve buffers, so even with the pressure on reserves this year, they remain at comfortable levels. Positive real rate differentials with the US provide an added element of protection.
Risk factors you should consider before investing:
- This material is not intended to provide investment advice or be considered a personal recommendation.
- The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
- Past results are not a guide to future results.
- If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
- Risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.
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