As global growth slows, there's an upside for international bonds As global growth slows, there's an upside for international bonds

As global growth slows, there's an upside for international bonds

Portfolio manager John Sidawi sees opportunities as headwinds in three key areas—Fed rate policy, the dollar's direction and idiosyncratic risks—shift to potential tailwinds.
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Q: As the year progresses, what are the prospects for international fixed income—both developed and emerging market?

It appears the recipe for U.S. dollar strength, namely U.S. growth outperformance and continued Federal Reserve rate hikes, may be reversing course. The Fed’s decision to pause on rate increases is a clear positive. Practically every other central bank is following its less hawkish if not dovish rhetoric and tone—the European Central Bank, Bank of Japan and a host of others, from Australia to Poland.

A weaker U.S. dollar typically translates to solid returns for international bonds in both emerging and developed markets, particularly on the local side—that is, international debt denominated in the issuer’s currency. Total returns for locally denominated bonds benefit directly from a weaker dollar as values from both the bond itself and its currency increase.

Q: What about impacts from slowing global growth?

Because it likely will keep prospects for higher yields in check, moderating global growth is a net positive for bonds. Also, except for a brief uptick in early 2018, real inflation in the developed world has been subdued for some time, with inflation expectations again on the decrease. For emerging markets, the concern centers on the magnitude of the global slowdown, which we believe will prove to be moderate. China continues to be the key variable. And while the data out of that country clearly signals deceleration, it doesn’t suggest contraction.

Q: How does the direction of interest rates and the U.S. dollar affect international fixed income? Are developed- and emerging-market (EM) assets impacted differently?

Generally, the direction of U.S. rates and monetary policy has impacts across all borders, be they developed or emerging, via credit flows, leverage and risk premiums. If EM activity rebounds thanks to a weakening dollar and less hawkish Fed, companies and countries around Europe should benefit as well, as global trade and business relationships cross all borders.

That said, emerging economies are particularly vulnerable to interest-rate shifts and the dollar’s valuation. There are three key reasons for this. First, most emerging economies are heavily reliant on foreign inflows to fund their fiscal or current account deficits. In order to attract that foreign inflow, they tend to offer higher interest rates relative to the U.S. and other developed markets. Second, many of these economies have taken advantage of low U.S. interest rates over the past several years by borrowing in U.S. dollars, so when U.S. rates and the dollar rise, it becomes more difficult to service that debt. A final, albeit less impactful factor involves emerging economies that are more dependent on commodity exports. Most of these commodities are priced in dollars and, over time, tend to have an inverse relationship to the dollar. So a strong dollar tends to depress these prices and vice versa.

Q: As the year progresses, what are you watching?

Geopolitics and central bank policy remain at the forefront. In Europe, we are monitoring continued political tensions and, of course, there’s the Brexit outcome in the U.K. Perhaps more significantly, particularly for emerging economies, is the outcome of U.S.-China trade negotiations, which will have a substantial effect on global risk premiums and their associated supply chains. From our perspective, recent news flows are beginning to reveal a de-escalation of this risk. A resolution of trade talks would serve as a catalyst for further currency appreciation, especially in emerging markets as well as in commodity-centric developed economies such as Canada and Australia. Overall, we believe many of these risks have been well vetted by the markets. As a result, bouts of expected volatility can serve as attractive entry points for investors.

Tags Fixed Income International/Global

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging-market and frontier-market securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.

Federated Investment Management Company