Pimco, GMO Refine EM Playbook as Fed Cuts Prepare to Rock Market

(Bloomberg) — Top-performing emerging-market bond managers are recalibrating their positions as the most-anticipated U.S. interest rate cut in decades brings fresh impetus to an asset class hit by nearly $15 billion in outflows. dollars this year.

Bloomberg’s most read

Investors from Pacific Investment Management Co. to Neuberger Berman and Grantham Mayo Van Otterloo & Co. looks at local currency debt and selects reform stories from countries like Ecuador and Argentina, which they say will benefit most from the upside Fed tapering should provide. to risk assets.

“You have to pick and choose. If you only own unhedged local bonds, you are carrying the full volatility of this index,” said Pramol Dhawan, head of emerging market debt at Pimco. He is neutral to underweight investment grade, overweight “some of the high yielders” and long local currency assets. “This is a portfolio that will work.”

Emerging markets have been hamstrung by volatility as global economic uncertainty and regional conflicts roil upbeat forecasts. A gauge of EM stocks gained about 14%, trailing a 26% rise for the S&P 500. Most recently, investors were left reeling from the plunging Mexican peso and wild swings in the Brazilian real on the backdrop of a mix of local woes and the decline of global carry trade positions.

Even so, funds from GMO, Neuberger and Pimco have outperformed more than 90% of their peers over the past year, returning more than 16%, compared with an average of more than 12% for 71 debt funds tracked by Bloomberg EM with over $500 million in assets. They have done so in part by riding substantial gains in high-yielding Latin American sovereign notes this year, a rally that is now set to slow as prices become more equitable.

With lower US rates, more money is expected to flow into emerging markets, which offer higher returns to investors. Bonds of developing nations saw a third year of outflows due to tight global financing conditions and geopolitical strife. Pimco’s Dhawan said the Fed’s tapering would set off a domino effect, prompting EM central banks to follow suit and potentially sparking a flow of capital into local markets.

The shift in markets has already started to emerge as the Fed clearly signaled a tapering in September. Last month was the best for EM domestic bonds this year, with yields above 2.3%, according to data compiled on a Bloomberg index. Local currency debt in developing countries has returned about half of what dollar bonds have earned over the past year.

The story continues

Local markets have been “a fairly strong trading strategy, even against the backdrop of the appreciation of the dollar,” said Dhawan, who prefers bonds and local currencies in Turkey and South Africa, as well as receiving long-term rates in Latin America. “If you are well diversified within EMFX, it was quite a profitable trade.”

Tina Vandersteel, who manages $6.1 billion in EM debt at GMO, echoes that view, favoring local assets in the Dominican Republic, Uruguay, Egypt and Nigeria.

“Local markets still have a relatively large valuation tailwind built into them,” she said.

However, investors will remain cautious about exposure to currencies such as the Brazilian real and the Mexican peso, which have underperformed. Samy Muaddi, head of emerging markets fixed income at T. Rowe Price, said he prefers to bet on local interest rate movements while hedging currencies.

Stories of reform

The biggest contributors to EM bond yields over the past year have been high-yield credit, which has risen more than 18%, compared with about 9% for investment-grade debt, according to data compiled by Bloomberg indices.

The ratings of some of the top performers — Ecuador and Argentina, boosted by economic reforms — have not lost favor. For Gorki Urquieta, who oversees about $25 billion in emerging market debt at Neuberger Berman, both still offer attractive returns despite lingering political risk.

“As long as things are going in the right direction in terms of reforms from the government,” he said. “There is still plenty of scope for yields and for spreads to compress.”

While investors may hold onto these bonds to reap the big coupons, it’s time to look beyond high-yield sovereign debt because they’ve become more equitable because they’re “extremely cheap,” T’s Muaddi said. Rowe.

EM bond funds have struggled to attract inflows amid the prospect of higher rates for longer in the US, posting just nine positive weeks this year, according to data from JPMorgan. While the $15 billion in outflows marks an improvement over an outflow of $31 billion in 2023 and an exodus of $90 billion in 2022, it underscores the challenge facing managers.

“EM is just one of those places that I think is rich in opportunities, but you don’t want to be last in the game,” Dhawan said. “You have to get a little ahead of the Fed on this and start reallocating your portfolios.”

What to watch

• In Brazil, the market is eyeing a second-quarter GDP print that should confirm robust economic expansion. Argentina’s central bank’s monthly survey of market expectations will be held on Thursday

• Inflation in Colombia is likely to continue to decline year-on-year, while Peru’s inflation rate is expected to fall to 2% in August.

• Countries including Indonesia, the Philippines, Thailand, Colombia and Peru report CPI data

• Nigeria’s GDP likely accelerated year-on-year in Q224, helped by an increase in activity in the oil sector

• In Asia, traders are eyeing China’s PMI data

Bloomberg Businessweek’s most read

©2024 Bloomberg LP