Bond investors have gotten used to the trappings of a perfect emerging-market trade, thanks to synchronized global growth and a weak U.S. dollar. Are they about to be shaken out of their comfort zone?
Yields on benchmark 10-year U.S. Treasurys are ticking higher, edging above 2.70% this week on expectations of higher inflation. For now, that is causing the spread between yields on Treasurys and emerging-market bonds — already at multiyear lows — to narrow further. The deluge of cash that has flooded into emerging-market sovereign and corporate bonds — more than $80 billion so far this year — is keeping their yields low even as those for Treasurys edge higher. Bond valuations in countries from Panama to Peru to the Philippines are looking stretched by historical standards.
The Federal Reserve's measured interest-rate increases to date have reassured investors, helping to avert any selloff like 2013's taper tantrum. The real test for markets will come if and when Treasury yields rise too fast, exposing overvalued assets.
But what is too fast? Anything above a 0.2 percentage-point increase a month in the 10-year Treasury benchmark yields could cause stress for emerging-market assets, according to Goldman Sachs, as investors pull back. Over the past month, yields on 10-year U.S. Treasurys have risen by around 0.3 percentage point.
One reason why the reaction in emerging-market bonds has so far been muted is that their long rally has been powered by so much cash that it would take huge outflows to cause a meaningful selloff, and a jump in yields.
Another comforting factor: The case for emerging markets is still underpinned by solid fundamentals, with growth firm in many countries and inflation under control. Valuations for emerging-market assets — including stocks and bonds — are running at their highest in two years, but are still below those in developed markets. Emerging-market currencies are still undervalued by 2% to 6%, according to Nomura.
Investors are getting jittery, dancing around yield curves and looking for higher-quality and more-liquid bonds. "A lot of what we do now is relative value," said Yacov Arnopolin, an emerging-markets portfolio manager at Pimco.
For sure, dramatic events such as the OPEC accord falling apart, a sudden downturn in China or a drastic Trumpian tariff move that derails trade could yet cause market turbulence. Political upheaval — not exactly unknown in emerging markets — remains a perennial threat. Absent such unforeseen events, however, the current uptrend may still have room to run. The question for investors is just how fast.