Hard currency sovereign bonds rose by 1.76%, corporate bonds by 3.29%, and local currency bonds, when measured in US dollars, by 4.28%.1 The largest contributions to returns for all asset classes derived from the interest component. Capital gains from contracting risk premiums were confined to specific countries or corporate credits, while the contribution from the US treasury component was marginally subtractive. Specifically for local currency markets, the contribution from interest rates outweighed the return generated from stronger currencies overall. The inflationary impetus from higher energy costs and mangled supply chains after Covid-19 restrictions were lifted are now fading, resulting in a relatively stable environment for emerging market bond yields. So-called second round effects, when workers demand higher wages to compensate for rising prices could still keep inflation higher than in previous cycles, but recent data releases point to a softening labor market. These trends have evolved at different speeds in different regions and across developed and emerging markets, but overall moderating consumer prices have now engulfed almost all countries. Central banks, in the late stages of policy interest rate adjustments already, are signaling an imminent pause. In some emerging markets, where policy makers have reacted early to the inflationary threat, rate setting committees are now in a position to start lowering interest rates amid precipitously falling inflation.
The outlook for China is still among the most cited investor concerns. Convergence in nominal GDP with the United States has stalled on account of falling prices, a feeble currency and weaker growth. The softening yuan however has not yet boosted exports; the latest data released for trade with the rest of the world has shown a drop in the proceeds from goods sold abroad. Domestically the economy is suffering from a slump in real estate. Within the sector, private property developers have defaulted on many dollar denominated obligations, closing an important avenue for refinancing existing debts. Consumer sentiment is weak, imperiled by falling housing prices, and youth unemployment rose to such heights that the Communist Party chose to stop publishing the figures. However, Chinese authorities have begun to announce several, often surgically targeted measures to boost the domestic economy in very specific ways. In our view this is consistent with the stated objective to improve the quality of growth, but if the strategy is successful, it could cocoon the country further inward. As a result we don’t expect Chinese economic activity to permeate as strongly outwards as it had in the past; the contribution to global growth from Chinese demand might diminish over time. More immediately, Chinese demand for commodities, particularly those needed for homebuilding will likely remain sluggish. For investors however, Chinese bond markets offer some very interesting opportunities, often entirely unaffected by the woes of property developers. Even more so, the strategic repositioning of growth and its inward orientation can give rise to new investment ideas within China and its surrounding regions; for example, the gaming sector in Macao, some sectors in Hong Kong or specific corporate credits in Indonesia and Malaysia.
The growth outlook for emerging markets has markedly brightened as the year progressed, despite the headwinds from China. We think this resilience bodes well for returns going forward and are further encouraged that drivers of higher growth are well diversified. We note that, apart from the obvious beneficiaries from higher crude oil prices, agriculturally oriented economies have performed well in recent quarters. Furthermore, the rebound in travel and tourism has helped services sectors across many emerging markets. Concerns over tightening financing conditions warrant close attention, but we are encouraged by the creativity of many borrowers, for example greater reliance on local funding options. The relative shift in interest rates, where the low inflation environment in Asia for example has compressed the yield differential with the United States and Europe, has fueled an uptake in domestic borrowing.
From a flow perspective, 2023 has been very unusual. Normally, investor appetite for emerging market bonds is closely correlated with performance, where in negative total return years investors withdraw funds from the asset class often exacerbating drawdowns, while in positive return years investors subscribe. This year so far, using flow information from the EFPR database, the asset class has seen outflows for over 80% of the weeks data was available, despite positive returns. This relationship of positive returns and outflows held true only once in the last 15 years, during the recessionary year of 2015, where a precipitous fall in commodity prices led to significant growth slowdowns across many emerging markets, while returns in absolute terms were positive owed to a strong rally in US treasuries. Overall we think that amid the growth outperformance for emerging markets, the resilience in financing and the more stable yield environment, a return of strategic inflows is all but a matter of time.