Global Emerging Markets Local Currency Debt - Monthly Commentary

October, 2010

Market review

Absolute returns remained very strong for the asset class in October with the benchmark returning 1.28% in US dollars. Less than 1 percentage point of return can be attributed to currency appreciation relative to the dollar; this is a little lower than the recent average. Emerging market currencies continue to attract strong flows as a result of improved fundamentals and high yields, but the threat of capital controls becoming more widespread is causing investors to be a little more selective in their allocations. 

Borrowing costs for the majority of emerging market sovereigns continue to fall with the benchmark index yielding 6.24% at month end – this is down over 100bp from the beginning of the year. This fall in yields is yet more positive for emerging market borrowers as it coincides with a 20bp increase in the average maturity as emerging market sovereigns seek to continue extending out their domestic yield curves and improve the overall profile of their debt structure.

Market outlook

The yield hungry environment looks set to continue following the Federal Reserves announcement that it will utilise an additional $600 billion in asset purchases over the next six months. However, investors need to keep a close eye on economic data over the coming months as this latest stimulus had been well signalled to the market and comes with a disclaimer that it can be withdrawn just as easily as it can be extended. News flow has by and large surprised to the upside in the past month but core inflation levels continue to fall and we retain the view that there is much to be done to close the existing output gap and reduce unemployment to an acceptable level. With this in mind we continue to believe that developed market government bond yields will remain low for an extended period and that the low cost of funding in the US will result in positive spill-over effects into the price of emerging bond markets.

Strategy

We had been selectively shortening duration at strategy level heading into Q3 as we felt that bond yields were beginning to be unreflective of the fundamentals in certain emerging market countries. This was particularly the case in Turkey and Hungary where strong cash flow drove longer dated bond yields ever lower. International participation in these markets is now back at or higher than pre-Lehman levels and as a result the yield differential between emerging and domestic borrowing costs is beginning to over-ride domestic risk factors. We believe that ultimately, borrowing costs should reflect the underlying fundamentals in each market and as such maintain short duration exposures in markets we feel are over-valued. By contrast the inflationary trend in South Africa continues to be downwards and the current inflation level is towards the lower end of the South African Reserve Banks target band. Given this low inflation rate, the weakening of leading indicators and the continued strength of the rand it is likely that the central bank will cut the repo rate a further 50bp in the coming months.

In Asia we retain our overweight exposure to Malaysia and Indonesia. We feel that Malaysia best captures the currency appreciation story that we associate with the strong economic growth characteristics of the region. Whilst in Indonesia, although close to fair value on the currency, we remain comfortable with the credit and feel the high yield associated with the bond market remains attractive.

In Latin America we continue to hold a 4% non - benchmark exposure to Argentina. The unfortunate passing of former President Nestor Kirchner has potentially loosened the political grip of the Kirchner family on the country and we are more hopeful of Argentina adopting a more market friendly economic policy mix ahead of the presidential elections. In Mexico, we feel the currency is the most undervalued in our universe relative to the fundamental story and demand for the country’s bonds is likely to remain strong given Mexico’s recent inclusion in the Citigroup World Government Bond Index. We remain overweight and long duration in Mexico. Although the long term fundamental story in Brazil remains attractive we feel that there is likely to be short term pressure on the currency given the appetite of the government to weaken the real. Brazil has incrementally increased its tax on foreign buyers of domestic bonds from 2% to 6% during October and have communicated to the market that they are prepared to enact further measures to restrict capital inflows. As such we continue to tactically hedge out our overweight currency exposure to the country.

CAUTION: The opinions expressed in this document are the views of Rexiter Capital Management Limited. This document is intended for institutional investors only and is not suitable for retail clients.