Chandler Bond Market Review

Emerging Markets and the Impact on U.S. Fixed Income

Investors’ fears of a potential crisis in emerging markets have become elevated in recent weeks, fueling financial market volatility. The safe-haven demand for U.S. Treasuries has increased as investors have been shifting away from emerging market assets. In January, the 10-year Treasury yield declined 38 basis points, as increased demand put downward pressure on yields. Meanwhile, the MSCI Emerging Markets Index (largely recognized as the most comprehensive index of emerging market equities) fell by 7% during the month.

MCSI Emerging Markets Index

Until recently, low interest rates in developed markets led investors to seek higher returns in emerging markets. The concern now is that the flow of capital investment into emerging markets fueled in part by U.S. quantitative easing over the past few years will reverse as the Fed tapers its asset purchases. Historically, a strengthening in the U.S. dollar has put downward pressure on emerging market currencies. Investor anxiety is centered on (but not limited to) a group of developing countries called the “Fragile Five” – Brazil, India, Indonesia, South Africa, and Turkey. Some market participants fear that a sudden flight of capital out of these countries could fuel a currency crisis, reminiscent of the Asian financial crisis in 1997, or lead to a global financial contagion. In theory, rising real interest rates in the U.S. (fueled by Fed tapering and less easy monetary policy), along with a favorable investment climate and an improving economy, should attract investors, driving increased demand for (and value of) the U.S. dollar. At the same time, concerns that emerging market economies (including China – the largest emerging market country) are cooling, could divert capital flows away from those countries and put downward pressure on their currencies. For the “Fragile Five”, particularly unfavorable economic conditions (characterized by weak economic growth, high levels of inflation, and large current account deficits) could potentially put significant downward pressure on their currencies and make it difficult for them to obtain foreign capital. An exodus of foreign capital coupled with a depreciation of the domestic currency would be problematic for certain developing countries because their large deficits are financed through external borrowing, and they must obtain foreign capital to pay back the principal and interest on their loans. Some market participants fear that the “Fragile Five” and other developing countries with significant short-term refinancing needs could be at risk of default if capital flows suddenly dry up, their foreign exchange reserves become insufficient, or if they experience sharp depreciations in their currencies.

Financial markets could continue to experience volatility as investors question the sustainability of China’s economic growth and as the U.S. Federal Reserve  continues to unwind quantitative easing.

In our view, fears of a currency crisis and subsequent financial contagion reminiscent of the Asian financial crisis are overblown. Emerging markets have changed since the 1990’s and most now function with free floating currencies and have stronger foreign currency reserves. Markets with free-floating currencies are essentially self-correcting; as the value of the currency weakens, the country’s exports should become cheaper, which should boost demand. We believe the issues facing emerging market economies will be contained, and are unlikely to drag the global economy into a crisis. However, we do believe that the financial markets could continue to experience volatility as investors question the sustainability of China’s economic growth (with China’s PMI falling to a 6-month low of 50.5 in January) and as the U.S. Federal Reserve continues to unwind quantitative easing. This volatility and uncertainty could be somewhat damaging to confidence and overall demand.

What does this mean for fixed income investors? Chandler has no direct exposure to sovereign emerging market debt. However, we do anticipate that ongoing concerns about emerging market economies could put downward pressure on Treasury yields over the next six to twelve months (while the U.S. Federal Reserve tapers its asset purchases), partially offsetting the upward force on rates caused by the winding down of quantitative easing and expectations for improving economic growth. Within the corporate bond market we could see a potential increase in credit spreads, though we think the impact of currency fluctuations on corporate earnings would generally be muted by companies’ geographic sales diversification and/or currency hedging mechanisms. In our view, the corporations that could be most affected by turmoil in emerging markets would be the Industrial Basics (commodities, metals, mining, chemicals, energy), those tied to manufacturing, or any companies that are highly sensitive to changes in global growth. However, an improving economic landscape in the U.S. and in Europe should help to offset weakness in emerging markets. Overall, we have a modest bias against corporate bond issuers with outsized exposure to emerging markets over the near- to intermediate-term, and favor companies that are poised to benefit from U.S. domestic economic growth and a potential upswing in U.S. consumer spending.

 

– Shelly Henbest

VP, Credit Analyst

 

 

 

 

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

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