Fundamentals

The fundamental backdrop for emerging markets is mixed, with the vaccine-driven growth rebound punctuated by ongoing macroeconomic setbacks. Economic deceleration in China and supply chain disruptions pose the greatest challenges, along with tightening financial conditions in the US and persistent inflation in emerging markets, which has not yet peaked. Strong inflation prints over the past year continue to push EM central banks to tighten policy well ahead of their DM peers, strengthening their credibility. For example, in Brazil, against a backdrop of upside surprises to inflation and an uncertain fiscal outlook, the central bank raised interest rates by 150 basis points (bps) to 9.25% in December, and hiked by another 150bps to 10.75% at its February meeting. There are very early signs that inflation may be peaking in countries that have followed similar accelerated monetary policy trajectories. If, as we expect, inflation starts to moderate in the first half of the year, then EM local currency duration should begin to look attractive. EM foreign exchange (EMFX) suffers from the same fundamental headwind of tighter US financial conditions, but remains cheap and is under-owned compared to history. The greater cushion now built into EM yields has seen EMFX outperform so far this year, at a time when G10 currencies have depreciated. It is clear that idiosyncratic risk remains in several EM regions, as evidenced by headlines across China’s property market and Ukrainian/Russian geopolitics. However, we currently view these risks as contained, with little chance of contagion across the EM debt complex.

EM central bank hiking cycle is well underway

Source: J.P. Morgan Asset Management; data as of 31 January 2022.

Quantitative valuations

Proactive EM central bank activity over the course of 2021 has driven an increase in yields across EM local currency bonds. So far, the hiking cycle has delivered a total increase of 3,270bps across central banks (including 1,005bps year to date and 325bps in the final week of January alone). 63% of EM central banks are currently hiking, while 32% (all in Asia) are on hold, and only a handful (5%) are cutting rates. This backdrop has led to significant value creation, with EM local currency government bond yields widening significantly both in absolute terms and relative to core rates. For example, Brazilian yields have risen from 6.9% in December 2020 to 11.1% (as of 31 January 2022). Despite the hawkish shift from DM central banks, they are lagging their EM counterparts in actually hiking rates, with the Federal Reserve not due to raise rates before March and the European Central Bank even further behind. EM ex-ante real yields (which incorporate an expected moderation in inflation) sit close to all-time wides. We are also seeing signals that EM local currency valuations are reaching levels of cheapness compared to hard currency EM sovereign bonds, while the attractive yield relative to duration profile of the EM local currency market (6.1% yield vs. 5.2 years duration) offers strong value and income in the context of global fixed income.

Technicals

The technical backdrop is supportive for emerging market debt. The second half of 2021 saw steady outflows from EM local currency funds, as investors capitulated amid relentless negative press. These outflows followed a generally anaemic flow backdrop for the last few years, leaving foreign ownership of EM local currency bonds looking very low in a historical context. As such, positioning is “clean”. Taking a simple average of all EM countries, foreign ownership sits at ~19%, well below the post taper tantrum high of ~25% (data as of December 2021). However, in recent weeks we have seen a deceleration of outflows and even some tentative inflows. Although investors remain cautious on the asset class, we do not expect to witness future outflows based solely on volatile newsflow. This forward-looking positive point in demand is slightly offset by the resumption of supply over the past weeks, which should continue unabated as we move into 2022.

About the Bond Bulletin

Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.

Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.