28 February 2018, 17:56 GMT
This content was first published on 31 January 2018.
2017 was a spectacular year for EM local currency nominal bonds. The yield on the benchmark GBI-EM index dropped 65bp, helping deliver a +8.9% total rates return in local currency terms. Impressive performance, especially compared to DM where rising yields left the GBI-DM index with a +1.3% total rates return. The key driver for EM rates returns last year was sharply falling inflation, which prompted Central Banks to ease policy rates.
Why was EM inflation so benign last year?
To forecast the outlook for EM inflation this year, it’s important to understand the two main reasons why it dropped so sharply in 2017. Firstly, EM currencies enjoyed a strong rally in 2016-17, appreciating +7% on average against the USD. This was in marked contrast to the 4-year period of sharp EM currency depreciation between 2011-2015, prompting a powerful base effect impact from pass-through inflation as imported goods collapsed in local currency price terms.
The second reason was falling global food prices. The El Nino phenomenon in 2015-16 heavily influenced weather patterns in Latin America with drought and flooding damaging crop yields in the region, driving global food prices higher. During 2017, El Nino dissipated and agricultural production recovered with harvests in many countries soaring. The trajectory of food prices spiking in 2016 and moderating in 2017 contributed to a sharp YoY base effect on EM inflation.
Where will EM inflation go in 2018?
We think the EM inflation cycle bottomed in Q4 2017 and the year ahead will see an upswing in price pressures. This shift is likely to come from four sources:
1. Base effects. We are already seeing signs that the benign base effects on food prices that characterised EM inflation during 2017 are fading.
2. Soaring energy and metals prices. Most notably the +25% jump in oil prices over the past year will increasingly manifest itself in EM headline inflation. EM Central Banks are already reacting, with most signalling the end of the easing cycle and some already hiking rates.
3. EM is booming. EM GDP growth is likely to hit +5% in 2018, the strongest year since 2011. Output gaps are closing quickly which will result in additional price pressures.
4. Currencies. We expect the USD to appreciate this year versus EMFX with the US adopting tighter monetary policy and looser fiscal policy. This is a textbook backdrop for Dollar appreciation and subsequent EMFX weakness will result in pass through inflation pressures.
Positioning for rising inflation
Following the 2017 rally, EM nominal bond yields have compressed significantly versus the US. The yield spread between the GBI-EM benchmark and US Treasuries has now tightened to just +350bp which is the bottom end of its 350-550bp range over the past decade. At the same time EM real yields still look comparatively cheap. Stripping out current inflation, the GBI-EM index real yield now stands at +175bp over the equivalent US real yields - around the average for the past decade.
With EM nominal yields now appearing rich compared to the US on a historical basis, EM real yields appear reasonably priced. In other words, EM inflation break evens seem too low. With EM inflation set to rise this year, and Central Banks likely to respond, we think the value in EM local duration is now in real yields rather than nominals. The risk/reward skew on EM inflation linked bonds is attractive at this juncture and we feel they offer good protection for EM local currency funds.
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