Money managers and strategists are betting that the Federal Reserve’s shift back to cutting interest rates will pour fuel on the biggest emerging-market bond rally in years.
A benchmark for domestic debt from developing-world governments this year has already handed investors a 15% return in dollar terms, putting it on track for the best year since at least 2017. The gains were unleashed after President Donald Trump’s trade war and rapid policy changes cast doubts on the outlook for the world’s largest economy, driving investors to shift some cash elsewhere.
Now, the Fed cutting rates again after a nine month pause is giving investors even more incentive to hunt for higher payouts elsewhere.
Local currency-denominated debt, whose returns would be amplified if the dollar keeps sliding, is a favorite investment of fund managers at Jeffrey Gundlach’s DoubleLine Capital and JPMorgan Asset Management. Neuberger Berman is favoring emerging-market currencies and local bonds. And Bank of America Corp. sees “no alternative” for the rest of the year that would rival EM carry trades — which involve borrowing in countries where interest rates are low and investing the money in those dangling higher returns.
“There’s definitely clear interest that people want to allocate to something that’s non dollar,” said Patrick Campbell, a portfolio manager at Morgan Stanley Investment Management. “We’ve seen a lot more interest in some of our more benchmark-aware strategies like EM local, which honestly we hadn’t seen since 2012.”
The positions reflect bets the Fed’s easing will continue to weigh on the dollar, which boosts the returns of bonds backed by appreciating currencies. It may also kindle carry trades that involve borrowing in the US.
Increasing Exposure
T. Rowe Price Group Inc. last week raised its exposure to bonds in emerging and frontier markets, betting that their relatively higher yields will attract global funds seeking to diversify away from the US.
“You can have these multi-year virtuous circles within emerging markets where capital inflows drive improving fundamentals, which will bring more capital inflows,” said Kenneth Orchard, head of international fixed income at the Baltimore-based firm, in an interview. “Our analysis suggests that we’re at the start of another one of those periods again.”
The Fed’s actions “continue to support the view for a weaker US dollar and lower rates looking forward,” said Nathan Thooft, a senior portfolio manager at Manulife Investment Management. “Both of which are supportive of emerging-market equities and debt.”
The rallies across emerging markets were fanned by Trump’s erratic tariff rollouts, which during the first half of the year sent the dollar tumbling by the most since the early 1970s. At the same time, interest rates have remained significantly higher in developing nations, where many central banks were more hesitant to ease monetary policy due to concerns about inflation.
The combination has driven emerging-market government debt to outperform most fixed income investments globally. The 15% jump is more than twice that of US corporate junk bonds, and compares with 5.4% gains in the Bloomberg US Treasury Index. The rally has been led by Brazil, Mexico, Colombia, Hungary and South Africa — all of which gained at least 23% this year.
The scale of the advance, of course, may limit the scope of future gains. Any restrengthening in the dollar — due to either scaled-back US rate-cut bets or heightened geopolitical tensions — could hurt sentiment. And selloffs in Turkey earlier this year and the rapid deterioration in Argentina this past week, which forced the central bank to burn through reserves, also underscore how quickly political jitters can upend emerging markets.
But analysts and investors said those will be outweighed by the more positive impacts of the Fed’s decision to ease policy on Wednesday, as well as indications of two more such moves by the end of the year.
That’s in part because developing-nation policymakers may follow suit, giving the bonds another boost. Inflation-adjusted yields in places like South Africa and Colombia will likely also keep drawing in cash from carry trades.
On average, emerging-market debt has returned between 6-8% in the wake of Fed rate cuts, according to Iain Stealey, the international CIO of fixed income at JPMorgan Asset Management. The JPMorgan Global Bond Opportunities fund — which he helps manage — continues to be overweight emerging markets.
Valerie Ho, a portfolio manager at DoubleLine, said her fund has pushed into positions focused on Brazil, South Africa and Hungary — all of which should get support from the Fed’s shift and a weaker dollar.
“Given this backdrop, we’re happy to keep these positions,” she said.
The returns have continued to draw cash into emerging-market funds. Those focused on debt lured about $300 million in the week ended Sept. 17 — the 22nd consecutive week of inflows, EPFR data compiled by BofA show. Year-to-date net inflows stand at $45 billion.
At PGIM Fixed Income, Cathy Hepworth took some chips off the table when it comes to hard-currency bets given the strong year-to-date run. Still, the head of EM debt continues with a short-dollar bias and has an overweight stance on higher-yielding currencies.
The current environment “continues to be supportive of emerging markets,” Hepworth said. “The direction of travel is clear.”
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