Christopher Mahon is the director of asset allocation research at Baring Multi Asset Group. He believes the Mexican bond market offers the best risk-return potential in the EM bond space.
Yields on developed government bonds are hitting all-time lows…
Investors have been left scratching their heads this summer as yields reached all-time lows.
For UK investors, this has been brought home by the Bank of England joining those central banks – including the European Central Bank and the Bank of Japan – in easing monetary policy. With yields on 10 year gilts hitting 0.5%, developed market government bonds appear increasingly ‘yield free’.
…making emerging market bonds attractive
Back in January 2014, the US 10 year note yielded 3%, and the typical emerging market bond yielded just below 6%.
Since then US Treasuries and emerging market bonds have seen 150bps and 90bps of yield compression respectively. In contrast, Mexican bonds haven’t experienced any meaningful yield compression at all.
Yields on Mexican bonds have been roughly constant over the past five years. It is almost as if the collapse in yields in developed markets never happened. Consequently, the yield pick up moving from US Treasuries to Mexican bonds is the widest it has been for years.
In fact, the rally in emerging market bonds this year has focused on the high yield countries like Brazil and Russia. Money has poured into these countries boosting their currencies and bond markets. This has left Mexico yielding slightly higher than the general emerging market bond universe.
Mexican growth depends on the US, not China…
In our opinion, while the yield story is helpful, what distinguishes Mexico from other emerging countries is the country’s ability to grow.
Mexico depends on the US economy, rather than China or Asia for its growth. This US reliance gives Mexico a far stronger foundation than countries depending on China for their export growth.
… with the result that Mexico is accelerating as other EM countries slow
It is true that certain emerging countries have been struggling recently. For instance, Brazil is in the grip of a multi-year recession. South Africa is struggling with low commodity prices, and Russia is recovering from the collapse in the oil price.
Mexico is different. While some quarters are weaker than others, the economy has been expanding over the last six years. At under 3%, inflation is well anchored. Supported by record remittances from overseas workers, the Mexican consumer is in rude health, with retail sales growing at 8% a year. Mexico is growing comfortably.
With growth in place, the peso won’t stay this cheap for long
A simple way of assessing the currency valuations in the emerging world is via purchasing power parity (PPP).
Looking at the headline exchange rates tends to mislead, given that many emerging currencies have wide and sustained variations in inflation. PPP helps strips out the inflation impact making it a fairer way of assessing longer term valuation trends in emerging currencies.
Using this approach, the Mexican peso is now cheaper than it was in the depths of 2008. Remarkably, the peso hasn’t been this cheap since the Tequila Crisis of the early 1990’s, following which the currency almost doubled in value over the following 10 years.
Comparing value against other emerging markets, the same basket of goods that costs $1 in the US costs just 44 cents in Mexico. This is now cheaper than Brazil (57 cents), despite Brazil being in a recession.
What is the risk?
Donald Trump as US President could be bad news for Mexico. Reasons include his plan to tax remittance payments to Mexico, and the potential withdrawal from The North American Free Trade Agreement.
While it is far from given that Trump will win the White House, or be able to control Congress enough to implement his policies, his candidacy remains a risk for the peso.
Nevertheless, from our work on PPP a lot of the bad news is already priced into the Peso. The currency is cheaper than in countries with far worse economic prospects.
How to profit from emerging market debt
Interest rates staying low will benefit all fixed income asset classes. Emerging market debt will be particularly rewarded given the higher yields on offer.
For us, while a lot of the rally in the emerging market bond world focused on higher yielding countries like Brazil and Russia, a more complete analysis should be conducted. This should not focus solely on yield, but on countries where there is significant potential for currency appreciation.
In our view, the Mexican bond market fits the bill very well. While the market may only be modestly higher yielding than a typical emerging market country, the peso will benefit from economic growth in US.
The market is less reliant on the uncertain growth picture of China.
But most importantly the cheapness of the peso should allow for healthy appreciation in the currency. Coupled with a decent level of income, Mexican bonds are one of our top picks for our multi asset portfolios.