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The impact of the U.K.'s Brexit decision in June to withdraw from the European Union continued to influence global markets as the month began. With developed markets government bond yields hitting record lows, investor focus turned away from the potential economic impact of Brexit and toward finding areas of the market where one can still earn sufficient income. According to J.P. Morgan, emerging markets (EM) debt funds appear to have been a significant beneficiary of the U.K.'s decision, attracting almost $14 billion globally in July alone.
As the markets appeared to have digested the near-term impacts of the U.K. referendum, geopolitical risk flared up again on July 15 with news of an attempted coup in Turkey. The immediate market impact of the failed coup attempt was a 4.6% plunge in the Turkish lira, already an underperformer for the year thus far, and significantly wider spreads on Turkish sovereign bonds. The country was already experiencing sluggish economic growth, impacted in part from a collapse in tourism, and weaker confidence may dampen potential improvement. Standard & Poor's responded with a downgrade of Turkey's credit rating to junk status, and Moody's Investors Service placed the country's credit rating on review. Although in general, economic fundamentals for emerging markets countries have turned more positive during the first half of 2016, such has not been the case for Turkey. Turkey's potential migration to sub-investment grade status would also have a fairly significant impact on emerging markets sovereign dollar indices, which have been losing their investment grade bias.
Meanwhile, the Federal Reserve (the "Fed") was interpreting mixed economic data that was announced throughout the month. Respectable employment reports in the first week of July led to the implied probability of a Fed hike at the December 2016 meeting rising from only 12% at the beginning of the month to 48% by mid-month. Expectations were tempered by the GDP release at month-end showing 1.2% annualized growth, far lower than expected. The U.S. dollar, which had been strengthening through July, pulled back on the news along with expectations of a rate hike this year. However, July's non-farm payrolls, released in the first week of August, surprised heavily on the upside, leading some to once again raise the prospect of at least one rate hike before 2017.
The search for yield seemed to outweigh concerns stemming from events in Turkey, the growth impacts of Brexit, and a decline in current oil prices. Emerging markets corporates had a strong July, returning 1.59% largely due to spread tightening. Hard currency sovereigns posted strong July performance of 1.80%, outperforming local currency bonds which returned 0.60% in U.S. dollar terms, with currencies impacting performance negatively. Despite the compression in yields, spreads on hard currency sovereigns remain slightly wider versus their 10-year historical average.
Unsurprisingly, Turkey was an underperformer in both local currency (-4.76% in USD) and hard currency (-3.01%). Oil producing countries such as Colombia, Russia, and Mexico were also laggards, as oil prices fell back towards $40 per barrel through the month. The impact of this decline has so far been limited, but sustained lower prices may pose a potential risk. South Africa was a notable outperformer during the month (+2.36% on hard currency bonds; +8.07% USD-return on local currency bonds). Although economic fundamentals remain sluggish, hope for political change in South Africa has boosted asset prices this year.
Investors' renewed interest in emerging markets debt amid the yield drought in developed markets is evidenced by the surge in flows this year that accelerated in July. According to J.P. Morgan, during the month, global flows amounted to an estimated $13.7 billion, almost 60% of year-to-date flows of $23.3 billion. Inflows of $4.7 billion toward the end of the month exceeded the previous weekly record set earlier in the month. Almost all flows have been into hard currency strategies, with local currency flows slightly positive at $0.7 billion.
Capital inflows, attractive yields in emerging markets (as shown below), and continued low and negative rates in developed markets continue to provide an extremely supportive backdrop for emerging markets bonds.
Yield Comparison: 10-Year Local Currency Sovereign Bonds (%) as of July 31, 2016
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