Emerging market bonds are poised to be one of the best performing asset classes this year as renewed US monetary stimulus boosts the divergence between the bonds' double-digit returns and lacklustre equities. Sovereign dollar bonds have already gained 12 percent on J. P Morgan's benchmark indexes in 2010, as cash-loaded investors fled near-zero G7 rates but avoided the volatility of stocks.
In contrast, MSCI's emerging stock index has posted flat returns, while other asset classes such as commodities have also trailed EM debt, giving up most of their gains this year.
The divergence may grow in coming months. By choosing to reinvest proceeds from its maturing mortgage holdings into Treasury bonds, the US Federal Reserve has kicked down the road plans to exit the unprecedented monetary stimulus delivered during the crisis. That's leading investors to expect more radical measures to support the economy - and so-called risk assets.
"Just get out of your cash - buy a tractor, buy a 10-year bond, buy emerging market debt, buy another currency. That's the message (from the Fed)," said Eric Fine, who helps manage $22.5 billion with New York-based fund manager Van Eck Global.
Admittedly, markets' knee-jerk reaction has been to cut risk, as growth fears have increased in the aftermath of the Fed move. Emerging market bonds remained resilient, however. Sovereign debt returns remained stable while emerging market stocks dropped nearly 4 percent since Tuesday.
The liquidity provided by the Fed is a "comfort blanket" for investors and "hugely positive" for emerging markets, said Phil Poole, head of global and macro strategy for HSBC Asset Management, with $90 billion invested in emerging markets.
"What's evident is an ongoing structural shift in asset allocation that favours emerging markets. In the current environment, when people are concerned about growth slowing, it should boost emerging fixed-income more than stocks," he said.
Despite robust growth in emerging markets, export-oriented companies will certainly feel the impact of any US slowdown. That makes investors wary of boosting equity allocations.
Data from fund tracker EPFR Global shows flows to emerging equity funds in the first half of 2010 were just over a third of levels seen in the previous six months. Bond fund flows, however, rose by a third and are at record levels.
Despite the Fed support for risk-taking, the market remains heavily focused on prospects of double-dip recession, said Mark Konyn, who oversees $11 billion as Asia-Pacific chief executive of RCM, a unit of Allianz Global Investors. "Cash is still building up with several institutions and there is a reluctance to allocate that cash," he said.
J. P Morgan's latest investor survey appears to confirm that. It showed funds now have a neutral position on emerging bonds after being overweight for 12 months. But, with cash balances up to 4.8 percent, it said technicals remain firmly positive.
J. P M expects already record inflows to emerging market debt to pick up further to a total of $70-$75 billion in 2010. More than half of these flows are going to local-currency government bonds, which post returns of about 9 percent so far this year. Those securities have benefited from the fact inflation pressures in most emerging markets have been lower than expected, allowing central banks to up rates more slowly.
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