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What the bond surge says about emerging markets

What the bond surge says about emerging markets
January 4, 2018
What the bond surge says about emerging markets

The health of China’s economy is pivotal, but it’s not the only game in town. India was one of three emerging market indices that gained more than 35 per cent in dollar terms, the others being South Korea and Hungary. India's benchmark S&P BSE Sensex index produced its best return since 2009, with a flood of local liquidity at the heart of the rally. Domestic capital outstripped inflows from foreign investors (in a cumulative two-year cycle) for the first time in seven years, a possible consequence of Narendra Modi’s demonetisation measures and the accompanying crackdown on the black economy. Meanwhile, the iShares MSCI South Korea ETF, known as EWY, was up almost 41 per cent, following losses in three out of the previous six years.

Based on recent statements, it appears that managed money will remain long on emerging market assets going forward. Asset managers, notably BlackRock, have voiced their optimism, while indicating they'll continue to invest in the segment this year. However, it’s not as though risk factors have suddenly evaporated. For a start, we’ve seen a gradual weakening in credit ratings. Sovereign ratings for some countries, including China and South Africa, have been downgraded, along with those for a number of high-profile corporations, on heightened risks over their ability to refinance debt as interest rates start to ratchet up.

Sovereign debt in emerging markets has been building on the back of continued economic growth, set against a backdrop of tightening monetary policy in the US. Last year saw record issuance from Saudi Arabia (leaving aside plans for a partial Saudi Aramco float), along with a flood of Chinese corporate bonds. It meant that 2017 was a record year for emerging market debt, evidenced by strong inflows into mandated bond funds, which looks set to continue.

Total bond sales topped $200bn, a rise of 16 per cent on 2016. Saudi Arabia alone raised $12.5bn in September following a record sukuk Islamic issue in April. Indeed, sukuk issuance increased by 11.7 per cent through the year, and ratings agency Moody’s anticipates a 55.7 per cent increase this year. (The steep rise in Saudi and Gulf State issuance might be a hangover from the prolonged slump in crude oil pricing). It’s also interesting to note that investors in initial public offerings don’t normally target emerging markets, except where specific mandates allow, but they are believed to have accounted for a significant portion of this year’s debt fund inflows.

All this activity in debt markets could simply underscore the BlackRock view that emerging market stocks should continue to outperform again this year on rising profitability, increased valuations and a reversion to equities. But there’s always the chance that renewed weakness in commodity prices could trigger a sell-off in risk assets. And we shouldn’t discount increased volatility resulting from heightened geopolitical risk. South Korea’s economy is in the shadow of its bellicose neighbour to the north, while Viktor Orbán’s Hungary could attract censure from another authoritarian regime in the form of the European Union. There are also 18 elections in emerging market countries through 2018, with the attendant risk of a sell-off in the event of an unexpected outcome – and we’ve had a few of those, lest we forget.