Having notched up around 175 interest rate cuts between them since early-2015, emerging market countries are about to extend a heavy policy easing cycle that has already helped bond investors earn double-digit returns this year.
In contrast to the United States, which is heading for a quarter point interest rate rise in December, and to palpable monetary easing fatigue in Japan and Europe, many developing countries have plenty of ammunition still at their disposal.
As the commodity price slump along with stuttering world growth reduces inflationary pressures, investors are betting the easing cycle — currently adding up to roughly one cut every four days — will encompass almost every big emerging economy, except perhaps Mexico and South Africa.
“We are going to see another big round of rate cuts in emerging markets, especially from many of the big players.
So for the local currency bond market it looks like a constructive environment,” said Didier Duret, chief investment officer at $4.5bn-asset ABN AMRO.
India underscored the trend this week as its new-minted monetary policy committee surprised markets with a 25 basis cut and signalled more to come.
In Brazil, rate futures are pricing a 78% probability the central bank will slice 25 basis points off its 14.25% rate on October 19, and then lops at least another 175 basis points off by end-2017.
But cuts may go beyond expectations.
HSBC for example expects Brazil to slash rates by as much as 300 basis points by end-2017, while reckoning on a cumulative 250 bps and 100 bps of cuts in Russia and Colombia respectively.
“Our call is that the central bank may deliver deeper rate cuts than is currently priced in,” said Murat Ulgen, head of emerging market research at HSBC, which has urged clients to “buy big in Brazil bonds”.
Similarly, Societe Generale predicts 150 bps worth of cuts in Russia over the coming nine months, contrasting with market expectations of 98 bps.
It also expects 50bps in South Korea, versus 12 bps priced by markets.
Bond prices tend to rally when interest rates fall.
So provided emerging currencies don’t buckle, local bonds should extend their bull run, having already returned 17% this year.
These gains were mainly driven by currencies’ rally against the dollar, with some units such as the Brazilian real up as much as 25%.
But local debt funds have received only around $10bn this year, a quarter of what has flowed to hard currency bonds, JP Morgan data shows.
Further gains should be driven by rate cuts.
“There are a lot of flows into local currency debt because currencies have stabilised, so now we are probably going to see a second wave,” ABN’s Duret said, adding emerging sovereign debt was his firm’s top bond market recommendation.
Other heavyweights expected to reduce rates include India, Indonesia, Malaysia, Argentina, Colombia, China and Turkey.
Most of these also fit the investor mantra of ‘reformers are performers’, with privatisations, subsidy removals and tax overhauls.
JP Morgan Asset Management also tips emerging local debt as next year’s top performing sector, with Nick Gartside, the firm’s fixed income CIO, saying the incoming rate cut wave “should be meaningful”.
But the dollar must have a quiet year for it to happen.
Gartside expects only one US rate rise in 2017 following one in December.
“Local EM debt very roughly gives you a 6.5% return so you should get that as a minimum (next year) but in an environment where currencies fall you very quickly lose that,” he said.
Another risk is Japan and the eurozone will “taper” or ease off monetary stimulus, raising their long-dated bond yields and reducing capital flows to emerging markets.
Therefore while short-dated emerging bonds may rally due to local monetary easing, “we are concerned that G3 rates could undermine EM duration,” Citi analysts told clients.
Duration is a measure of how much bond yields may change if interest rates rise or fall.
Possibly that’s why, authorities — except in Turkey — have moved cautiously, fearing aggressive rate cuts will leave currencies vulnerable should the global backdrop sour.
Russia and India for instance have defied politicians’ calls for faster rate cuts, and Russian Central Bank Governor Elvira Nabiullina warned recently she might keep rates at 10% in 2016 — well above 6.9% inflation.
Because of the caution, the average premium on local currency bonds versus five-year US Treasuries is in the upper 90th percentile when looking back the last six years, UBS strategist Manik Narain estimates.
The room for improvement makes them attractive, leading the likes of Jan Dehn, head of research at Ashmore to expect 2017 to be another year of 10% plus returns.