Highly publicised outflows from all EM sectors may create difficulties for non-strategic countries with sizeable short-term foreign debt to refinance. Many of those countries are in Central Europe, where we have reduced our bond exposure to a negligible level and are net short at-risk regional currencies such as the Bulgarian lev and Polish zloty.
Emerging local yields that we like include Mexico and South Africa. We expect their local central banks to keep rate adjustments on hold for much of the next two years (contrary to market pricing). A significant portion of our focused EM exposure is held via interest rate swaps, which allows us to avoid the direct foreign exchange risk of physical bonds. In Brazil, the market is currently pricing in 200 bps of rate hikes over the coming 24 months, which is excessive in our view. Brazilian bonds yield nearly 13%, which is well in excess of forecast growth of 2% and inflation of 6%. We also like Brazilian inflation-linked bonds with a real yield of over 6%.
In countries where there are current account problems (Turkey, South Africa, Brazil, India and Indonesia) we have, in most currencies, removed any residual currency exposure within the portfolios, materially reduced the longs, or even adopted an outright short position (in South African rand).
Credit
One area that did well all year, and will therefore struggle to repeat its 2013 performance, is credit. Since April, the asset sub-class behaved more in line with equity markets than government bonds (i.e. performed well), but is now trading so close to government debt that any further spread tightening will be limited and short-lived. New bond issues are coming by the dozen, as companies seek to take advantage of the low interest rates, and European banks are unwilling to lend directly as much as before.
Convertible bonds
Another area that has done well, but has the potential to repeat its success, is convertible bonds. The threatened great rotation out of cash and some bonds into equities has indeed happened in every major country. Many industry practitioners agree that equity values are somewhat stretched in various areas. But momentum could take us higher to levels comparable to the price action of 1997.
Government bonds
Government bonds have done badly in price terms and may not recover in a V-shaped manner. While it can be argued that US government bonds fell too far and one year too early, imminent Fed tapering greatly limits the immediate upside from here. For 2014, the US tapering probably will hurt intermediate US bonds, and growth in the UK will put the fear into gilts (here, we have options that benefit from higher yields in both markets in coming years).
Japan
Inflation is one factor that we have not embraced in a major way for years. Given recent disinflation and fall-from-favour by inflation-linked bonds, this has been no bad thing. 2015 might be inflationary, so it may be wise to materially allocate to inflation-linked bonds (or inflation swaps) in a few quarters’ time.
Strategy for 2014
Our strategy, as always, is for a gentle rotation towards highest value, alongside a wide array of protection bought against outcomes on selected factors that could impinge on the portfolios. If markets repeat their historic behaviour, but deliver more bear quarters for government bonds, we are confident that this strategy will continue to add value.
