An EMerging Problem — Evening Brief – 07.02.24
Nearly half of the global population will be participating in elections this year. Recently, a series of election outcomes in emerging markets (EM) have unsettled investors in local currency debt.
The recent elections in South Africa, Mexico, and India resulted in a significant rise in local government bond yields and a sharp decline in currency assets, according to commentary from Man Institute’s Views from the Floor.
South Africa was one of the poorest performing local currency markets in May, thanks to negative sentiment after the African National Congress’s vote share got drubbed, weakening to just shy of its lowest level of the year versus the U.S. dollar at 18.95.
In Mexico, conversely, a much better-than-expected showing for the ruling party in Mexico increased local political risk and drove the Mexican peso to its lowest level since March 2023 versus the U.S. dollar at 18.98.
In India, Prime Minister Narendra Modi’s party failed to secure a majority in the lower house of Parliament. To establish the next government, the party must appeal to its allies, which has weakened bonds and the Indian rupee. The rupee is currently trading at all-time lows versus the U.S. dollar.
Notwithstanding these political changes, the primary factor influencing EM debt assets and the local currency so far this year remains U.S. economic data, according to Man Institute.
The dovish position taken by Federal Reserve Chair Jerome Powell in early May resulted in a narrative of a ‘soft landing’ and prompted a partial relief rally in U.S. government bond yields, as well as a decline in the U.S. dollar. However, optimism diminished when Fed speakers expressed more hawkish views and the minutes from the FOMC meeting revealed a sense of caution.
Most recently, better-than-expected inflation data led to a boost in optimism. However, the optimism was dampened by the Fed’s decision to maintain interest rates at their current level and indicate that it anticipates only one rate cut this year.
EM currencies continue to face pressure from a strong US dollar and shrinking interest-rate differentials. Man Institute stated that the slower-than-anticipated decrease in inflation and changes in currency values have led to more cautious actions by EM central banks, which may cause investors to “delay” investing in assets with longer durations, as they become more susceptible to changes in interest rates. This is particularly true for currencies that have low yields, it added.
Until there is more clarity that the Fed is going to cut rates, the opportunity cost for EM fixed income assets remains high, given the current level of US yields, noted Man Institute.
“Investors are not currently being compensated for the plethora of tail risks the asset class faces, ranging from ongoing conflicts to surprise election outcomes. In short, current valuations limit the potential for EM appreciation or local yields rallying. Against this backdrop, an overall defensive risk stance is warranted.”