SEVERAL factors have contributed to this year's outperformance in the Asian and emerging markets fixedincome space:
- A TALE OF TWO EMS The key theme in EM local rates this year has been dispersion. A story of two different EMs has unfolded: declining inflation in high-yielding countries has coexisted with rising or bottoming inflation in most low-yielding countries. Lowerthan- expected inflation has allowed some central banks, such as India and Indonesia, to cut interest rates, while the rest of Asia has remained on hold. In the year to end-August, Asian yields outperformed the US 10-year Treasury yield by 20bps and in the sell-off since September they have outperformed by eight bps.
- SUPPORTIVE GLOBAL FACTORS The global macroeconomic environment has been supportive for EM bonds. Global growth has been revised up during the year (although the most recent revisions were downward) and leading indicators point to continued strong momentum. Meanwhile, inflation has been surprising on the downside. Trade volumes and prices have also risen this year, which historically have a multiplier effect on EM growth and a positive impact on their currencies through the terms of trade channel.
- RELATIVE VALUE Rich valuations in other asset classes have attracted flows into EM fixed income, from both traditional EM debt investors as well as cross-over investors. According to JP Morgan, cumulative inflows into local Asian bond markets amounted to US$60.3 billion by September, compared with US$13.8 billion into Asia ex-Japan equity markets. Asia accounted for just over half of flows into EM local-bond markets. The largest bond flows have been into Indonesia and India, consistent with the high yielder / rate cutting theme. Going forward, we expect flows into China to pick up notably as it is eventually included in Global Bond Indices.
Unlike 2017, there is a less clear macro-theme for 2018. Alpha-generation and country-level dispersion will likely prove a much stronger theme. Indonesia and India are close to, or at the end, of their rate-cutting cycles. Moreover, several markets are starting shallow rate-hiking cycles, such as South Korea, Taiwan and the Philippines.
The bottom line is that the strong tailwinds which drove EM yields markedly lower this year are less pronounced going forward, although yields can continue to grind lower. Therefore, EM yields will likely become more sensitive to idiosyncratic factors. Investors are also more likely to maximise interest income if capital appreciation opportunities aren't as obvious.
The growth environment should remain supportive, with India forecast to have the largest yearon- year increase in GDP growth in 2018. The EM inflation outlook also looks benign with inflation remaining within the target range for most countries at the end of next year. In China, we expect circa 6.2 per cent year-on-year GDP growth and continued progress on the reform agenda.
However, there remains risk of volatility coming from micro-stresses in the economy, particularly if they concide with slowing growth and other global factors. This appears to be a continuation of the same environment as 2017 but there are two key differences that investors should take into account in 2018:
- The first is the G-4 central bank reduction - contraction of balance sheets occurs towards the middle of the year. Historical data suggests that much of the flows in and out of EM bonds can be explained by global liquidity conditions in general and central bank balance sheet changes in particular.
- The second is global inflation, particularly US inflation. This has been a key pillar of the benign environment, despite continued Fed interest rate hikes. Any sign that a strong labour market and increased wage growth is spilling over to higher underlying inflation would lead to a reassessment of the framework that markets have become accustomed to over the past several years. W
Cristiana de Alessi is emerging markets rates portfolio manager at BNP Paribas Asset Management.