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EM credit rally strong despite negative rating actions

The EM rally has significantly benefited fixed income across developing economies. Although it will eventually slow, the participation of large institutional flows will yet carry it forward. Mainly negative ratings actions concerning EMs have not affected the rally, as such activity tend to come after the markets have moved forward.

Jul 29, 2016 // 5:13PM

EMs globally are in the middle of a rally. This has so far been driven by existing investors shifting more money into EMs, either by using up available liquidity or through extending leverage.

“The big institutional flows have not even begun yet. When they start chasing returns (they always follow rallies) we will get another leg higher,” said Jan Dehn, head of research at Ashmore Investment Management.

He added that the technical picture across EMs remains very strong despite years of selling. “The market is not currently overbought and valuations are still reasonable.”

Fixed income has been the main beneficiary of the EM rally. The reasons behind this are that EM fixed income is mispriced in relation to its DM counterpart, and a repricing of elevated US stocks could have a significant impact on EM equities.

“Investors are also generally risk averse, because they are massively overinvested in developed market assets after chasing QE purchases for half a decade. Scared investors are more likely to buy bonds than stocks.”

The cause of the rally can be linked to attractive valuations in EMs. Dehn noted that as recently as February, the average yield on EM bonds was higher than when the US Fed had interest rates at 5.375%.

Low yields across DM bonds are also having a positive effect on EM fixed income. According to Bloomberg, 10-year government bond yields in the US are 1.52%. In the UK they are 0.73%, whilst in Germany and Japan they are in negative territory at -0.07% and -0.20% respectively.

This is in comparison to 11.80% in Brazil, 5.91% in Mexico and 7.17% in India, Bloomberg data showed. As a result, the opportunity cost of EM bonds at present is relatively low.

Investors have also been driven to EMs by the fact that their fundamentals are either stable, or even improving, whilst DM countries are facing revised growth rates.

The IMF recently revised down US and UK growth rates, whilst raising China’s growth outlook. EM technicals also remain relatively strong, as evidenced by the modest reaction in EM assets to Brexit, the Turkish coup and US Fed policy.

The stabilisation of the US dollar in relation to EM currencies has also steadied outflows. The Brazilian real has spent most of the past month hovering around the 3.2750 mark according to data from Bloomberg.

The rally will inevitably slow however. Dehn noted that there is already a partial slowdown due to summer holidays, but going forward US interest rate hikes leading to a stronger dollar, as well as fears over the US presidential election could also damage the rally’s progress.

Despite the positive outlook held by investors on EMs, recent credit rating activity is painting a darker picture. Of 16 EM and 10 frontier markets where rating action was taken, only 2 were positive.

However, Dehn stated that the ratings agencies tend to be late, and that by the time they have carried out a rating action the markets have moved much further on.

“In fact, downgrades are often excellent indicators of turning points. I think most sophisticated investors know this already,” he said.

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