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.
Fast view
- Behavioural biases can create compelling entry points in the bond markets of economies that are in the advanced stages in their rate-hiking cycle.
- Typically, when a hiking cycle is 80-90% complete, investors overestimate the size and duration of the hiking cycle, leaving bonds undervalued.
- Investors that enter the market at this point in the rate-hiking cycle rather than waiting for it to turn typically generate better returns.
- Many emerging markets are well ahead of developed markets in their hiking cycles. Our fundamental inflation and monetary policy analysis shows us that inflation peaks tend to coincide with interest rate peaks. In combination with current market pricing, this suggests that many EM economies are now close their terminal (peak) interest rate.
- We are beginning to see exciting opportunities in emerging markets where real rates are highest (e.g., Brazil, Chile, Mexico).
Introduction
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.
Historical hiking cycles reveal clear patterns
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.
Case study: South Africa
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.
- Point A: the bond market pricing implies that the rate hiking cycle is 17% complete when it is really only 10% of the way through. In effect, the market is underpricing the peak in rates (bond valuations are expensive).
- Point B: the bond market pricing implies that the rate hiking cycle is only 64% of the way through when it is almost completed (80%); the market is overpricing the peak in rates and bonds are undervalued.
Finding the right entry point has created compelling returns
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.
Looking at the EM universe through the hiking-cycle lens
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.
Specific risk:
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.
General risk:
All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.
Indices:
Indices are shown for illustrative purposes only, are unmanaged and do not take into account market conditions or the costs associated with investing. Further, the manager’s strategy may deploy investment techniques and instruments not used to generate Index performance. For this reason, the performance of the manager and the Indices are not directly comparable.
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