Global liquidity outlook drives EM bonds higher....For now - BBH

Research Team at BBH, notes that the world’s major central banks continue to ease, driving down developed market yields to record lows.  

Key Quotes

“Some estimates put the total amount of global bonds with negative rates at around $10 trln. As global investors search for yield, funds are naturally finding their way into EM.  

What Changed?

The Bank of England, the Bank of Japan, the RBA, and the RBNZ (assuming they cut later today) have all eased in recent weeks in response to growing economic headwinds.  Further easing is also possible by several other central banks in the developed world.  With zero and/or negative interest rates prevailing in a large segment of the developed world bond markets, it seems natural that money seeking positive returns would flow into EM.  

The latest data from the Institute for International Finance (IIF) clearly support this narrative.  Total portfolio investment flows to EM have been positive in June and July, and in 4 of the past 5 months.   Data so far in August suggest the inflows are continuing.  To underscore just how tough it’s been for EM over the last year, the 12-month total inflows just turned positive in July, to the tune of $900 mln.  While small, this was the first positive 12-month total since December.  We suspect fund flows into EM will continue over the next several months.  

Who Benefits?

The decline in yields is a global phenomenon.  In DM, the biggest drops in 10-year yields are New Zealand (-141 bp), the UK (-136 bp), Sweden (-98 bp), and Spain (-85 bp).  

Turning to EM, the biggest drops in 10-year yields in Asia are in Indonesia (-200 bp), the Philippines (-83 bp), and Korea (-68 bp).  In Latin America, they are in Brazil (-467 bp), Peru (-175 bp), and Colombia (-116 bp).  Lastly, in EMEA, the biggest drops are in Russia (-135 bp), South Africa (-113 bp), and Turkey (-106 bp).  

Further gains for EM bonds appear likely.  While the US appears to be strengthening in Q3, H1 softness has helped push out Fed tightening expectations significantly.  We believe the September 21 meeting is too soon to hike again, while the November 2 meeting may be avoided due to the proximity of the US elections.  That leaves the December 14 FOMC meeting.  With the ECB, BOE, and BOJ potentially easing further in the coming weeks, we foresee a nice window, a sweet spot if you will, where EM can continue to gain traction.

Conclusion

Emerging Markets have been buffeted by a variety of negative factors this year, but have remained resilient.  The overriding factor here is that the global liquidity backdrop remains supportive for “risk.”  We expect this favorable outlook to continue into year-end.  

However, a purely liquidity driven model of investing will work….until it doesn’t.  We caution investors against getting too optimistic about EM, as fundamentals are lagging the price action in many cases.  Rather than view it as a large monolithic entity, we have long felt that investors must be more discerning and to view each country on its own merits.  The global investment climate remains difficult, and now is not the time for complacency.”