The global disinflationary trajectory has been established as inflation has fallen significantly over the last six to twelve months. Emerging markets (EM) central banks have begun cutting rates, and developed markets (DM) central banks are likely to follow later this year.
Our view is that regardless of which DM central bank – the US Federal Reserve, European Central Bank or Bank of England – moves first, rate cuts should be supportive for duration-linked assets such as sovereign bonds. We think it is warranted in a sovereign bond strategy to increase overall duration given the likely move lower in yields.
However, markets seem to be assigning a very high probability to a risk-friendly, soft landing economic scenario. We are more sceptical that this can be achieved based on historical economic cycles. There are many potential risks this year ranging from volatile election-year politics to heightened geopolitical tensions in Ukraine/Russia and Israel/Gaza.
We find it incongruous that risk-asset valuations remain so ebullient. Equity markets have touched records this year, and sovereign and credit spreads are extremely expensive. We think it makes sense to have a very conservative exposure to spreads. We think it makes sense to be taking outright short exposure to credit spreads — positioning for spreads to widen in both developed and emerging markets.
EM local currency sovereigns
As unconstrained and truly global investors, we continue to see compelling opportunities in the current environment. We believe that select EM currencies and local-currency sovereign bonds offer attractive carry and total return potential. EM local-currency sovereign bonds make up about 15% of standard global government bond indices today, up from 4% 10 years ago. The EM weighting is expected to go up further.
Our top pick currently is local-currency sovereign bonds in India. The country has strong GDP growth, stable inflation and is offering 7% carry for a currency that has displayed very low volatility in recent months. These yields compare favourably with other Asian markets such as South Korea and China. In recent years, Asia has proven itself to be a low-inflation continent.
India’s equity market has attracted a lot of attention, but local currency bonds haven’t seen significant inflows. That may change as the bonds enter sovereign benchmark indices, including JPMorgan and Bloomberg; we expect that a lot of money will be flowing into India, and this will support its balance of payments position.
We think investing in India today has a similar profile to investments in China in the 1990s. The last 30 years have been China’s period of growth, and the next 10, 20 or 30 years could be India’s.
Frontier market prospects
We also see opportunities in frontier markets — countries that are less developed than DMs or EMs. Although this is a higher risk space, it is rich with opportunities to generate alpha and to deliver uncorrelated returns to broader financial markets.
One of these frontier markets is Egypt – post the large devaluation recently; we see the Egyptian pound as undervalued and attractive to take long exposure. Egypt has agreed to an IMF loan programme, with the UAE and Saudi Arabia also providing support, all of which have provided ample foreign currency reserves to support the valuation of the pound. Egypt borders Gaza and Israel, so it is near the epicentre of a geopolitical crisis. Yet, we believe for this reason that the US, Europe and the key regional players don’t want Egypt to be pushed into further financial stress.
As active sovereign investors, we can diversify the portfolio by identifying countries that may be at different points of their own economic cycle and take positions accordingly. When buying local-currency sovereign bonds, for example, investors have exposure to both currency risk and rates (duration) risk. As active investors, we are able to hedge the currency risk and, for example, USD-hedged EM local-currency sovereign bonds have performed much better than currency-unhedged over the last 20 years.
We believe that by globally diversifying the portfolio, and by taking an active approach to choosing rates, sovereign spread or currency risk, we have the potential to deliver superior returns.
The value of active minds: independent thinking
A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.
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