The performance of global bond market since the middle of May should serve as a wake up call for investors, says Adrian Mowat, Chief Asian, Emerging Equity Strategist, JP Morgan. Since bullishness in bonds led to bond-yields getting compressed, it attracted capital. Therefore, emerging market bond markets became overvalued.
Speaking to CNBC-TV18 he says the impending tapering of quantitative easing (QE) by Fed could push up bond yields. This could be bad for emerging markets which then face the risks of inflow sqeeze as well as outflows. It could be negative for EM currencies and also push up interest rates particularly for those EMs with open capital accounts, he adds. However, he feels India’s domestic monetary conditions are somewhat isolated. India amongst the emerging markets where monetary policy is easing hence "I would be buying India quite aggressively at this level in the currency."
Year-to-date the Indian equity market has outperformed EMs by 2 percent in dollar terms and by 6 percent in local currency terms.
Below is the verbatim transcript of his interview on CNBC-TV18
Q: You have been talking about this phenomenon of Emerging Market (EM) underperformance relative to the US. Do you see this kind of trend in both currencies and equities in EMs getting even more accentuated in days to come?
A: There is a risk that it does. What happens in global bond markets since the middle of May was a bit of a wake up call. For a very protracted period of time we have had bullish environment in bonds; bond yields continued to get compressed and that attracted more capital. We ended up with bond markets becoming very overvalued relative to the risk that you are taking on and that is particularly true in the emerging world.
Now, as we look at the reality of QE tapering, the fact that what the Fed is doing it is successful i.e. it is generating growth - the correspondence of that is going to be higher bond yields, and a tough environment where you get a bit of capital loss in bond markets. That is bad news for the EM. It could result in smaller flows or even outflows, but that would generate a tendency towards currency weakness versus the US dollar. It could also push up interest rates in these EMs particularly those with more open capital accounts.
India is interesting and unusual in this context. India’s domestic monetary conditions are somewhat isolated. Indian bonds rallied by 50 bps in May. It was a complete outlier, everywhere else we were seeing an increase in bond yields and a tightening in monetary conditions. So the pain in India as you have highlighted just now is being felt with the currency.
The Indian equity market is still outperforming EMs year-to-date (YTD) in dollar terms by about 2 percent, but if it was in local currency terms India would be outperforming EMs by 6 percent.
Q: The moves on these EM currencies are being read as precursors to the fact that there is a period of sharp risk-off coming generally, for asset classes in the second half. Would you say that it looks like a likely outcome that risk levels are going to be far higher from here?
A: What happened in the Japanese government bond market starting on 14th of May, generated a risk-off move throughout asset classes whether that be equity, fixed income, currency. So you saw the dollar weakening; the trades’ people had - were long dollar, short Yen, and short euro. You saw a dramatic sell-off in the Japanese equity market which had performed very well. Throughout EMs, we saw the good performing markets tending to underperform in May as positions were unwound.
I would suggest that we have probably done a fair amount of unwinding of risk positions and I would expect investors to gradually return to where there is fundamental strength. So, I would see some of the smaller Association of Southeast Asian Nations (ASEAN) markets beginning to recover. If we can get some political resolution in Turkey, we see a lot of interest and value there. I would be buying India quite aggressively at this level in the currency, because India is one of the few places that we find in EMs where monetary policy is easing domestically.