(2) Emerging markets - IMF spring meeting
Expect a lot of talks about the emerging markets this week as the IMF meeting unfolds. As mentioned above, a recent report highlights the risk that if the Federal Reserve unexpectedly signals inflation concerns, it could trigger a selloff in the EMs space. The report calls for "clear central bank communication" to avoid a scenario such as the feared "taper tantrum". We suspect that there is an understanding of how dependent emerging markets have become on debt in the past five years behind the report. Indeed, developing countries have seen lower interest rates in the US as an opportunity to issue cheap US dollar debt, gearing themselves up. Suppose yields continue to rise in the United States, and the US dollar doesn't devalue. In that case, EMs might run into severe refinancing and default risk, which would cut them out from lifeline funds.
We have been vocal about the importance to create a buffer against rising yields in the United States by seeking coupon income. High yield corporate and emerging market bonds can provide such a buffer. When looking at the EMs, local currencies can contribute to the bond's total return by adding currency risk premia. However, let's look at bonds performance in the first quarter of the year (see chart below). On average, bonds across all currencies provided negative returns, except for Chinese renminbi bonds. The problem stems from the fact that a recovery in the EMs will diverge from the one in advanced economies due to vaccination pace. Additionally, developing countries have limited fiscal stimulus potential. Outflows from EM bond ETFs are accelerating as investors realize that emerging market risk rises together with US bond yields and the danger of a "policy surprise" from the Fed. However, the good news that the cheaper EMs bonds are getting, the better opportunity is for investors to pick some of these up. Indeed, economic recovery and higher inflation in the US should positively impact EM debt as soon as the fear of monetary policy mistakes diminishes.