Investec co-head of Emerging Market Fixed Income Peter Eerdmans believes markets are overpricing the risk of an interest rate rise in emerging economies next year and that the US Federal Reserve was 'teaching the market a lesson' when it decided not to taper three months ago.
This latter view was down to the fact that he believes the Fed thought markets had tightened too much in anticipation of tapering.
Due to this, the impact of tapering when it finally comes would be less serious than previously feared as much of the move would already be priced in according to Eerdmans.
Teaching the market a lesson
He said: 'We think that the Fed was trying to teach the market a lesson when it withdrew the expected taper. In other words, it felt that monetary conditions had tightened too much in anticipation. US 10 year yields went from 1.6% to 3% in four months. Although markets subsequently recovered, we are still now at around 2.7%.
'So we are starting from a high level, and hence any sell-off should be more contained.'
While Eerdmans also thinks EMD yields will rise in 2014, he predicts that the asset class will continue to generate 'attractive' returns for investors.
'We think current yields on local currency emerging market bonds of around 6.7% are appropriate given the current fairly benign level of inflation in emerging markets of just over 4%.
'We actually think the market is somewhat overpricing the risk of rising rates. We do anticipate yields to rise but given some fairly technical factors (shape of yield curve, carry/yield levels, and the effect of coupons) we think that returns should still remain attractive.'
He is sticking with his central scenario that local currency EM debt will post an annualised 5-6% for each of the next five years in US dollar terms.
This is somewhat lower than the around 10% returns we have seen over the past decade, but a good return nevertheless if realised.
Most bearish assumption
He said that even under his most bearish assumption - which assumed a 5% currency loss every year for the next five years - the asset class should still not incur a capital loss.
In terms of the best opportunities within emerging market debt, Eerdmans continues to favour the consensus favourite Mexico, on the back of its strong government reforms and close ties to the US economy, but he also sees value in some relatively more unloved currencies such as the Indonesian rupiah and the Russian ruble which have endured significant weakness in 2013.
'We like fairly beaten up currencies such as the Indonesian rupiah and the Indian rupee. In general we think the theme of weaker emerging market FX has been overplayed.'
Eerdmans believes that when US tapering does finally arrive, it may ultimately lead to outoerformance by EMD.
'Emerging market bonds were trading at a spread of 3.8% over US 10 year Treasuries before the Federal Reserve’s ‘non-tapering decision’. The spread is now wider than that [so] therefore I think that when tapering does actually happen the impact could be smaller than expected.
'We think it is quite possible that whilst US Treasury yields are likely to rise in 2014 the spread with EMD could compress, leading to EMD outperforming US treasuries.'