Notes from the road: Colombia and Peru
Nicolas Jaquier reports on his recent trip to Colombia and Peru, where political risks are receding and sustainable finance opportunities are emerging.
16 Aug 2022
Over recent months, interest-rate hikes have created a conundrum for fixed income investors across the globe. Yet behavioural biases can create compelling entry points in the bond markets of countries that have reached a certain point in their rate-hiking cycle. Active EM debt investors should seek to harness this market inefficiency. In this piece, we examine behavioural biases seen in multiple hiking cycles over 20 years across EM and consider which EM debt markets appear most attractive in this context.
We analysed 79 interest-rate hiking cycles that have taken place in EM over the past 20-years. This revealed a clear pattern of behaviour among fixed income investors:
|Point in hiking cycle||Behavioural bias||Bond market valuations|
|Early stage||Market participants typically underestimate how far the hiking cycle has advanced.||Overvalued (the negative impact of hiking is underestimated).|
|Late stage (hiking cycle 80-90% complete)||Market perception typically shifts too far in the opposite direction, with investors overestimating the size and duration of the hiking cycle.||Undervalued (the negative impact of hiking is overestimated).|
|Post-hiking cycle||Investors re-enter the bond market once the hiking cycle finishes.||Valuations recover.|
Investors that buck the trend and enter the market at the late stage of the rate-hiking cycle (when market prices are unjustifiably low) rather than waiting for the cycle to turn typically generate better returns. In the South Africa case study shared below, the best time to invest in the country’s debt would have been when the hiking cycle was around 80% of the way through, when the priced peak was at its highest.
Figure 1. South Africa hiking cycle in 2013-2016
Source: Bloomberg, Ninety One calculations.
The left-hand axis shows the policy rate and the right-hand axis shows this as a percentage of the eventual peak policy rate for that hiking cycle. The dark green line shows how the policy rate climbed to its eventual peak of 7.00%. The light green line is the peak rate that South Africa’s bond market priced at each point in time, with the pink line showing this in terms of the percentage of the peak policy rate.
This reveals that early in the hiking cycle, South Africa’s bond market participants thought that the hiking cycle had already advanced further than it actually had, reflected in the underpricing of the peak rate (pink line below dark green line); this situation reversed later in the hiking cycle as perceptions shifted and market participants feared that the hiking cycle had significantly further to go, overestimating the peak rate (pink line overshoots the dark green), resulting in depressed bond market valuations which corrected as it was evident the cycle was complete.
This pattern of market behaviour is one that has generally been repeated across a large number of the EM hiking cycles we analysed; the aggregate picture is represented Figure 2.
Figure 2. Market expectations vs actual rate-hiking cycle
Source: Ninety One as at 8 July 2022. Dataset includes 79 hiking cycles in EM since 2003, 53 of those cycles >180 days and 28 of those cycles >=300bps. Medians are used.
How to read Figure 2: 0% on the axes represents the aggregate start of the hiking cycle and 100% is the end of it (i.e., when the peak policy rate is reached). The squares show the percentage of the peak rate that the market prices in at each point in time, which can be compared to the solid line which shows where the country actually was in the cycle.
In Figure 3 we see that 3-month hedged bond market returns across the yield curve (2, 5 and 10-year bonds) turn positive towards the end of the hiking cycle as the market begins to correct its overpricing of the monetary cycle peak. As countries’ central banks come close to the end of their hiking cycles, expected investment returns naturally become more compelling.
Figure 3. Returns of bonds (2, 5 and 10 years to maturity) over the subsequent 3 months at different points in rate hiking cycle
Source: Ninety One as at 8 July 2022. Bond returns are equal duration positions, hedged, i.e., 10% in a 2-year bond hedged with 10% FX forward. Dataset includes 79 hiking cycles in EM since 2003, 53 of those cycles >180 days and 28 of those cycles >=300bps. Medians are used.
Many emerging market economies are well ahead of their DM peers in terms of hiking cycles, as evidenced by the significantly higher one-year forward real-interest rates seen in EM. Meanwhile, on average (excluding China, Russia and Taiwan), the market currently prices EMs as being 65% through their hiking cycles.
Figure 4. Progress through hiking cycles by market, relative to market pricing of peak rates
Source: Ninety One as at 31 July 2022. ‘When calculating the EM average progress we consider all EM’s except Russia (has been cutting), China (not hiking) and Taiwan (difficult to price). % = the progress through the cycle as priced by the market.
Our fundamental inflation and monetary policy analysis shows us that inflation peaks typically coincide with interest rate peaks; when we then look at this in combination with an analysis of market pricing (Figure 4), many EM economies now appear close their terminal interest rate.
Generally, when a hiking cycle is approaching its end (80-90%), investors are presented with an attractive entry point. We are beginning to see some exciting opportunities in many of our markets where real rates are highest (e.g., Brazil, Chile, Mexico).
This is not a buy, sell or hold recommendation for any particular security.
Emerging market: These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.
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