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Global emerging markets ("EM") debt, both hard and local currency, rebounded strongly in June after a significant retracement in May. One of the main drivers behind the resumption of the EM debt rally was yet another shift in interest rate expectations, following a very weak U.S. employment release on June 3. The U.K. Brexit vote on June 23 was an even more significant event, one that placed a very large exclamation point on the renewed expectations for "lower for longer."
As unpredictable as the Brexit decision was, the fact that the resulting selloff in risk markets reversed so quickly, yet rates continued to fall, was equally difficult to forecast. The net result has been that by early July, some $11.5 trillion in bonds were trading at negative rates, with 58% of the Barclays US Aggregate Bond Index1 trading below 1%. Thus, the hunt for yield continued as aggressively as ever. Given the impact that the more hawkish tone struck by the Federal Open Market Committee members had on debt markets in May, the rapidity of the shift back to extremely dovish expectations is somewhat unsettling and leaves one wondering how quickly expectations can swing back the other way.
In the near term, the precarious position of European banks – a situation that has persisted but has moved in and out of focus over the last four years – in combination with a variety of risks to global growth prospects will likely keep the hawks at bay. While global growth statistics remain within muted expectations, EM debt and equity could remain the beneficiaries of additional capital flows for some time. The inflows to EM debt funds to date in 2016 are quite small relative to what left EM debt funds in 2015.
Under current conditions, we expect to see an acceleration of inflows during the second half of the year. Valuations, positive real rates of interest, and EM central banks with (conventional) policy flexibility are all supportive of the case for EM. The risks are many, including further growth deceleration and a reversal in the commodity price recovery. On the flip side, a rate shock, as unlikely as it may seem at the moment, could cause a sharp reversal in flows to various debt asset classes, including EM.
Within emerging markets, the Brexit impact, predictably, was felt most poignantly in Central and Eastern Europe. These countries have the highest dependence on Britain and the EU for trade. Romania, Poland, and Hungary were the laggards in the local currency space, while high beta countries such as Brazil, South Africa, and Colombia posted total returns (from both local interest rates and foreign currency movements) of between 10% and 15% in June alone. Despite recovering 1.8% in June, Mexico's local debt is the only major market with a negative return year-to-date return (-2%) for the first half of 2016, all due to persistent weakness in the peso. In hard currency markets, Venezuelan debt continued to recover, returning more than 12% in June. Brazilian, South African, and Colombian sovereign and corporate U.S. dollar-denominated bonds were among the top performers as well, particularly sovereign bonds with returns in excess of 5%. That being said, overall in June, credit spreads on hard currency EM debt were only marginally tighter (virtually unchanged in the corporate markets). Duration and the U.S. Treasury rally were very much the drivers of return.
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