22 Nov 2022
Recent economic data prints, especially on inflation in the US, suggest that light is finally appearing at the end of the tunnel, following a painful year in bond markets.
In early November, a very encouraging US consumer price index (CPI) print came in well below expectations – across both headline and core. While we don’t want to overplay the importance of this single data point, it has provided a significant amount of relief to markets (and the Fed, no doubt!) as it follows a long string of quite meaningful upside surprises to inflation.
Inflation surprises: US CPI prints vs. consensus expectations
Source: Bloomberg as at November 2022.
More recently, producer price index (PPI) data for the US also, encouragingly, came in below expectations. Meanwhile, oil prices remain fairly well behaved – the WTI price has remained largely flat over the past few months and is 20% down on the June 2022 levels – while gas prices in Europe have fallen considerably. While this certainly does not mean we are in the clear, we think it serves as an important reminder for market participants, policymakers and economists that surprises won’t keep going in one direction forever. For us, it has increased our conviction in forecasts that all point to inflation easing into 2023. In effect, it helps lower the probability of a nasty tail-risk scenario of inflation continuing to rise into next year.
Given how negative market sentiment has become and how high cash balances are, investor positioning in EM debt has become very cautious. We think this, in combination with lower uncertainty over the outlook for inflation, is an encouraging mix.
Following a very challenging year for bond markets, EM debt market valuations are very attractive. We believe that all that is needed to lure back some of those high cash balances/reverse the significant outflows EM debt and equities have suffered is a reduction in US Treasury market volatility from extremely high levels. The MOVE index shown below – a yield-curve weighted index of the normalised implied volatility on 1-month Treasury options – gives cause for optimism that stability is starting to return to the US Treasury market.
ICE Bank of America MOVE Index
Source: Bloomberg, Bank of America, as at November 2022.
We are already observing that investors are increasingly re-embracing EM, encouraged by highly compelling starting yields which we believe are ultimately underpinned by solid fundamentals: after a year of proactive monetary policy, inflation is peaking against a backdrop of relatively strong external accounts – the picture is robust for EM in aggregate.
It is clear that risks remain. The US Federal Reserve (Fed) won’t want financial conditions to ease too much – as markets rally, financial conditions loosen, thus undoing efforts to tighten policy, cool the economy and bring down inflation; the Fed is likely to ramp up the hawkish rhetoric to slow the market. Furthermore, activity data in the US has been encouraging (for instance, the Atlanta Fed’s Q4 GDP nowcast remains very robust). Strong data reduces the risk of a ‘hard landing’ recession and may encourage the Fed to tighten more through 2023. Elsewhere, Europe continues to face significant challenges heading in to winter as real incomes decline and temperatures cool.
But there have also been some other mildly encouraging signs beyond the monetary policy front. While Ukraine seems to have the upper hand against Russian forces, an increasing number of military analysts suggest that fears of a nuclear rebuke from Putin are perhaps misplaced and there are hints of some behind-the-scenes diplomacy. In China, the authorities have stepped up their efforts to support the real estate sector, thus helping to curtail another negative tail risk the market had feared.
Putting this all together, we believe EM debt investors should feel more comfortable in embracing the current market volatility, knowing it’s always difficult to call the bottom and recognising the current value on offer. Across our strategies, we have increased top-down risk, predominantly through EM currencies (reducing our US dollar overweight), while remaining overweight in both local and hard currency bonds.
While clearly not out of the ‘inflationary woods’ yet, EM debt investors should be encouraged by the combination of recent economic data prints (especially for inflation in the US), valuations and market positioning, against a backdrop of robust EM fundamentals.
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