EMD and the great inflation debate
Reza Karim, Fund Manager, Emerging Market Debt, explains why EMD hasn’t performed in line with expectations this year, and how higher inflation is impacting the asset class.
There’s often a difference between the consensus narrative about what investors should do, and what the market actually does. At the beginning of the year, the narrative was bullish on emerging market debt (EMD) – put simply, the expectations were that Biden’s stimulus would cause the US dollar to weaken, which would be positive for the asset class. But instead, in the first quarter EM FX was down about 5%, because volatility in US treasuries took centre stage, not US dollar weakness. So far in the second quarter EM FX has recovered, but year to date it is roughly flat, which is still widely different from the bullish narrative at the start of the year.
Now, the narrative has shifted to the inflation debate. There are three major stances: first, that inflation will be transitory; second, that inflation will be permanent; and third (and a view that’s gaining more traction), that inflation will be transitory, but it will be transitory at such a high level that it will still cause US treasuries to crash, and at the same time risk appetite will fall due to US treasury volatility.
From our perspective, we don’t believe it’s necessary to pick one of these three stances, as regardless we will still aim to pick the highest yielding names available that we don’t think will default and we don’t believe have any major negative catalysts. We also place a lot of importance on diversification.
So, how is inflation impacting EMD? First, it has created a distortion within markets. The best protection from inflation is high yield debt, which means high yield valuations are looking stretched. Second, while orderly inflation is unlikely to negatively impact high yield debt, any major unexpected spikes in US treasury yields will be negative for EM high yield. Debt levels in EM countries, and to a smaller extent in EM corporates, have increased due to the pandemic. That’s fine while we’re seeing an uptick in growth, but as soon as the funding costs of that growth increase, it’s likely to create a market wobble.
Despite the consensus narrative, in reality, the market is essentially loading up on the lowest-rated debt available, and hoping for the best – i.e. the more hairy the debt, the better it is performing. Year to date, inflows are at around $39bn, and the pace of these flows is picking up. In terms of sovereigns, Ecuador and Sri Lanka have been the best performers, while B-rated corporate bonds have been the strongest in the corporate universe. Those primary issuers that were unable to issue a few years ago due to their poor credit quality are now able to issue debt with record demand. When the market is running hot like this, we tend to take a cautious approach, choosing not to chase rallies, but staying selective instead.
More positively, if the underlying reason for inflation is a commodity supercycle, this can be hugely beneficial for the EM countries and corporates that are producers of these commodities. As such, we favour economies that have large commodity exposure, like Ukraine and South Africa. We also have a preference for high yield, which has been the best performing segment of the market, but given valuations are getting stretched it is important to be selective. Meanwhile, in our view the yields offered by the asset class as a whole still look attractive compared to other debt markets, meaning that inflows are likely to continue to pick up.
Bond markets feeling braver about inflation
James Novotny, Assistant Fund Manager, Fixed Income, discusses the calmer reaction by bond markets to growing inflation in recent months, as a consensus view takes hold that inflation pressures are more likely to be transitory than permanent.
The recent moves in US Treasuries are hard to ignore, in my view. After all the scaremongering that happened after the April CPI print, the narrative of runaway inflation never gained much traction. I think there are two reasons for that, firstly that the Federal Reserve didn’t react to the print itself, and secondly that the underlying drivers of the print were transitory (e.g. base effects, used car prices).
The consensus opinion in the debate between transitory and permanent inflationary drivers has shifted in favour of the transitory camp. One of the measures we look at is Core PCE, which strips out the most volatile components of CPI, and that looks much softer than headline inflation figures.
The market definitely feels braver when it comes to inflation, and bond yields actually fell in reaction to the May CPI print. Non-farm payrolls are also a factor, with recent relatively subdued figures giving investors greater confidence that the Fed won’t need to take policy action.
More broadly, what we’re seeing in the market is a rotation away from near-term inflationary fears into a view on global reflationary and assets across the rest of the world. In May, for example, some assets that had underperformed in the recovery coming back into their own – South African rates is one example, which offer a high real yield and a strong domestic backdrop with its commodity exposure.
Looking ahead, we are concerned about potential US dollar weakness and about whether this trend towards global assets can continue, and Fed policy will continue to be key.
Pent up demand of the UK consumer
An excess of savings points to future consumer support for the UK economy, says Luke Kerr, Fund Manager, UK Small & Mid Cap.
The continuation of COVID restrictions may be frustrating, but there is a silver lining. UK consumers’ pent-up demand, evidenced by an excess of savings will, in my view, give strong support to the UK economy for several years into the future.
The pandemic restrictions mean UK consumers have been unable to spend, especially on holidays. Instead, they have been saving. Household bank deposits in the UK have been running at around £125 billion above trend. This is a huge amount. To put it into context, the excess savings are almost double the average (pre-pandemic) UK spend on holidays, about £65 billion per year. In other words, the UK consumer has squirreled away about two annual holidays’ worth of excess cash. In my view excess savings will only increase as the government’s continuing restrictions on travel mean that few UK residents will be able to holiday abroad this year.
That excess cash will be spent eventually. Such a huge amount will not be spent all at once, of course. I foresee steady, strong support for the UK economy as excess savings are gradually released during coming years. I expect a three-to-five year period of well-above average UK consumer spending.
I am therefore especially positive about prospects for the building trade, as consumers work on repairing, maintaining and improving their homes. However, I am wary of seeking too instant a gratification: spending in garden centres, for example, may already have peaked. (We only need to buy new garden furniture once.) Demand for extensions and improvements to houses, on the other hand, is not being fully met, and will probably persist for several years.
The value of active minds: independent thinking
A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.
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