BlackRock’s dollar-denominated emerging market bond ETF was among the top three fixed income inflows last week as investors turned more risk-on following a lower-than-expected US inflation reading.
According to data from Ultumus, the $8.2bn iShares J.P. Morgan $ EM Bond UCITS ETF (SEMB) saw $366m inflows in the week to 12 August, the third largest inflow of the week after investment grade bond and longer duration US Treasuries ETFs.
In a note, Morgan Stanley turned bullish on emerging market sovereign credit for the first time since 2020, Bloomberg reported, as an 8.5% consumer price inflation (CPI) reading in the US inspired a risk rally and saw investors cut bets on continued hawkishness by the Federal Reserve.
Morgan Stanley analyst Simon Waever said the yield spread between emerging market sovereign debt and US Treasuries continued to trend downward after hitting a two-year high in July. He argued spreads could contract as much as 50 basis points in the months ahead.
The drop in yields demanded by investors to take on emerging market debt (EMD) exposure has naturally sparked a period of positive returns in benchmarks such as the JP Morgan EMBI Global Core index tracked by SEMB which has in turn encouraged the recent wave of inflows.
For most of H1, EMD was firmly out of fashion as sovereign and corporate issuers faced the pressures of paying back debt denominated in an increasingly strengthening US dollar. Also, fears of recession across major economies spurred many investors to turn risk-off, preferring fixed income safe havens such as US Treasuries.
Between less hawkish signalling from the Fed at its last policy meeting and the less severe US CPI reading last week, investors have felt more comfortable hunting for opportunities further down the credit rating scale.
Whether this proves to be the right decision will be tested at the Fed’s Jackson Hole meeting next week, where markets will hear chair Jerome Powell’s messaging on the state of the economy and his plans for the next round of interest rate hikes.
JP Morgan remains cautious about how long the EMD rally can be sustained. Last week, strategists led by Trang Nguyen suggested clients should offload less liquid exposures at opportunistic prices and buy into hedge positions ahead of a sell-off, Bloomberg reported.
The bank said while spreads may continue to shrink in line with inflows, its strategists continue to be defensive in its fixed income allocations.
“While imminent recession fears have eased compared to our last report one month ago, the combination of tighter monetary conditions and lingering recession risks should continue to pose key cyclical headwinds for emerging market sovereigns,” its analysts said.