Is inflation creating a buying opportunity in emerging market bonds?

Inflation is everywhere. Not just at the petrol pump or in the supermarket, but on the front pages of the papers as more and more policy makers and consumers get worried and voice their concerns more strongly.

Whereas the intensity of the news flow on inflation might suggest it is a relatively recent phenomenon, for us as bond investors, inflation is always at the top of our agenda. A very significant part of our process actually centres on forecasting the outlook for inflation. This shouldn’t come as a surprise as inflation erodes the value of our future fixed income payments and hence causes bond prices to drop.

Inflation has been increasing steadily for about a year now in the emerging markets universe (see Graph 1). This has been driven mostly by higher food and fuel prices on the back of higher commodity demand. This has made it very much a global trend with every region, and in fact, pretty much every single country is experiencing higher inflation. Emerging markets are particularly exposed at the present time because of the high weightings of food and fuel in their inflation measures.

Graph 1: Average headline CPI by region; equally weighted; source: Datastream

Since the middle of last year bond yields have started to react to inflation and have gone up steadily. As the red line in Graph 2 (below) shows, yields have gone up from about 6.5% on average to well over 8% currently. This is a big move and of course quite negative for bond prices.

However, overall returns for the local currency Emerging Markets Debt (EMD) asset class have still been very good – as illustrated in the blue line in Graph 2 the representative index has gone up by approximately 10% since the middle of last year.

Graph 2: Total return (in USD) and yield on the JP Morgan GBI-EM Broad Diversified index; source JP Morgan

This positive return on the index - despite the substantial increase in yields - is thanks to two ‘buffering’ factors:

1. High starting yields - at an average yield of around 7% over the past year, bond prices have quite a lot of protection before returns would turn negative. Roughly speaking, bonds with a duration of 4 years could withstand almost 2% of yield rises before showing a negative return.

2. Currency appreciation - returns in our universe come from three key areas: yields, capital returns on bonds and capital returns on the currencies. The returns on currencies have been very strong over the past year. Ironically these positive returns are mainly thanks to higher commodities prices (which is good for the trade balance of many countries in our universe) as well as a willingness among emerging markets policy makers to let their currencies strengthen to help fight inflation

From here, we think bond yields might be relatively close to the top. We have found many markets have anticipated the inflation that everyone is now talking about, and already priced in the risks. As one can also see from Graph 2, at over 8% yields for the universe are substantially higher than at any point since the index was launched at the end of 2002. At this level there is, in our view, a lot of bad (inflation) news priced in.

The inflation trend is still quite strong, and while we are therefore not taking a lot of risk based on this view yet, we have added to positions in selected markets where yields have increased dramatically. One such example is Turkey where yields increased from 15% last year to 21% at the middle of June. With inflation at 10.7% most recently and the central bank now focused on fighting inflation, we believe yields over 20% are very attractive.

Most central banks in our universe are now clearly in tightening mode (we have seen over 75% of the banks we follow raise interest rates at least once this year). More needs to be done, but we believe that central banks are now acting, with some beginning to tighten more than anticipated by the markets. We believe this should help bring growth and inflation downwards later in the year and into 2009. In addition, higher fuel and food prices are acting as a tax on growth. We are already seeing consumer sentiment dropping sharply in many countries in our universe on the back of the higher fuel prices.

Finally, many commodities (with the important exception of oil and corn) are already falling from the highs seen earlier in the year. Although we are not negative on commodities, one should note that as long as commodities rise less than last year, their inflationary impact should also be less for the year to come. The one thing to watch very carefully is second round effects. With growth still strong in most emerging markets, tight labour markets mean the risks of higher wage demands are real. We believe central banks have built up enough credibility to anchor inflation expectations, but this is a test of their resolve.

All in all, we acknowledge that inflation is a central issue and poses a threat to our asset class. However, we believe high yields are now pricing in a lot of bad news and with the increasing likelihood of further currency strength and central banks acting to bring inflation down, we are more inclined to buy emerging market bonds than sell. In our fund, we have taken the first steps in this direction.