A visitor views the electronic board displaying stock activity at the Brasil Bolsa Bacao (B3) stock exchange in Sao Paulo, Brazil. (Photographer: Patricia Monteiro/Bloomberg)

Emerging Market Bond Bulls Can Take Heart From Dismal Inflation

(Bloomberg) -- Investors nervous about whether the bull case for emerging-market assets can weather a more hawkish Federal Reserve can take solace in the outlook for consumer prices.

While inflation in developing economies languishes near a record low, prices are starting to tick higher in the developed world, including the U.S., as wage and other costs rise. That’s positive for emerging bonds, with 16 of 21 markets included in the Bloomberg Barclays Emerging Markets Local Currency Government Index offering higher yields than the U.S. when adjusted for inflation, according to data compiled by Bloomberg.

Emerging Market Bond Bulls Can Take Heart From Dismal Inflation

Brazil leads the pack, with its 10-year real-denominated bonds offering inflation-adjusted yields of almost 7 percent, followed by Russia’s ruble notes at 4.7 percent. That compares with the real yields of 0.7 percent on Treasury bonds due in a decade. At the other end of the spectrum is local-currency debt of Egypt and Nigeria, which have negative real yields.

Concern over policy normalization by the Fed, European Central Bank, and potentially even the Bank of Japan, has rattled the EM investment case, along with speculation the revival in developed-market inflation could start to spread. But with markets fixated on the benchmark Treasury yield’s march toward 3 percent amid expectations over Fed tightening, the real yield premium makes emerging-market assets stand out, according to Mitsubishi UFJ Kokusai Asset Management Co.

No Threat

“The current level of U.S. real yield doesn’t pose much threat to developing currencies,” said Kiyoshi Ishigane, Tokyo-based chief strategist at MUFJ Kokusai, which oversaw the equivalent of $129 billion at the end of 2017. “It’s not like the U.S. real yield is now at 2 percent, making it hard to justify going after emerging-market assets.”

Falling commodity prices and stable currencies have kept a lid on developing-nation inflation, which is the least diverged from that of developing markets in a decade, Danske Bank A/S analysts Vladimir Miklashevsky and Jakob Christensen wrote in a Feb. 27 note.

Emerging Market Bond Bulls Can Take Heart From Dismal Inflation

“Carry trades and yield hunting have become attractive across many emerging markets as real rates are high,” the Danske analysts wrote. “Despite reflation beginning in advanced economies and higher oil prices, we expect the relatively low emerging market inflation rates to persist in 2018.”

The market is also in a better position for buying after losses amid last month’s global stock rout, the U.S. yield spike and now new Fed Chair Jerome Powell’s hawkish shift.

February Declines

The MSCI index of emerging-market currencies declined 0.7 percent in February, after rising 6.2 percent in the previous three months, while the Bloomberg Barclays EM local currency government debt index completed its first monthly drop since October. The currency measure declined 0.2 percent as of 6:48 a.m. in London on Thursday.

Among the markets offering higher real yields, Brazil’s inflation rate is near the lowest since 1999, while Russia’s dropped to its lowest level in the country’s modern history in January.

“If you’re looking to invest in emerging markets using local currencies, you wouldn’t want to be facing inflation where the value of your assets continue to depreciate,” said Kota Hirayama, a senior economist for emerging markets at SMBC Nikko Securities Inc. in Tokyo. “So if you’ve got a situation where inflation is easing, leading to a stable currency and therefore eliminating currency risks, money tends to flow in for decent yields.”

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