This article is part of Morningstar's "Perspectives" series, written by third-party contributors.
When investing in emerging market bonds, correctly assessing the countries’ various economic cycles is key to determining how to build or avoid exposures.
Some countries may be in ‘crisis’, such as Venezuela at the current time, while others may be ‘stabilising’ after a problematic period. In the former phase, the country’s currency is likely to come under great pressure as the economy goes into crisis. As a result, inflation overshoots and the central bank is forced to hike interest rates to counter rising prices and capital outflows. In an environment of rising country risk, bond prices fall. Taking short positions in a country’s bond or foreign exchange market can be a useful strategy if either its economic outlook is particularly unfavourable, or if valuations, particularly on the FX side, look significantly overstretched.
For stabilising countries, there will be firm evidence that the economy is bottoming out. However, at this stage inflation is still high and/or rising, with local bond yields lacking attraction. It is important to assess these environments very closely, with the intention of picking the turning point to add investment opportunities.
On a selective basis, sovereign and corporate bond allocations can offer upside potential in these instances, while long exposure to the local currency may also be appealing. Ecuador provides a case in point in this category. Oil production is very important for its economy and, therefore, it has benefited from the recent rise in oil prices. GDP growth was -1.5% in 2016, but is forecast to have been modestly positive in 2017, to exhibit a typical ‘bottoming out’ trend.
Economic Recovery Supports Local Currencies
Encouragingly, many emerging market economies progress from the stabilising backdrop to an ‘improving’ stage. During these times, an economy displays healthy recovery signals, such as an appreciating currency and declining inflation expectations.
In turn, lower inflation can add compelling real yields to the investment case for the country. Monetary policy is also likely to help bond investors’ sentiment, given that as inflation peaks the central bank can support the economy by lowering interest rates.
Egypt is in such an improving economic cycle. Relevantly, tourists are returning to the country, helping to accelerate its growth outlook, with GDP growth forecast at more than 4% in the current year and in 2019. Furthermore, high inflation – triggered by the break from a currency peg – should have peaked and real yields are supportive. It is important to remember that changes in currency exchange rates will affect the value of investments.
If an economy progresses to a boom cycle, EM bond investors can weigh up some key risks and opportunities. In these cycles, inflation rises above the central bank’s target, a consequence of the economy overheating. In addition, the country’s currency valuation is likely to be high, and there is the prospect of interest rate rises to counter inflation and balance the economy. This background typically warrants staying short in terms of the local currency.
Romania currently appears in boom territory, producing a hefty 7% growth in GDP in 2017. Such an increase suggests the economy is growing above potential, with rate tightening by the National Bank of Romania already taking place in the first quarter of 2018.
The positive side in a boom scenario is that default risk is low. Additional value can be found by investing in companies that benefit from the robust economic environment, especially those with output geared to the local economy.
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