Brexit triggers surprise emerging market asset rally

[July 02, 2016]  By Dion Rabouin
 
 NEW YORK (Reuters) - When British voters shocked world markets by voting to leave the European Union last week, emerging markets assets seemed among the most vulnerable to a full-on retreat to safe havens from riskier investments.

Yet as investors have realized that the vote and the resulting uncertainty will probably keep the U.S. Federal Reserve on the sidelines at least until December, emerging currencies, stocks and sovereign bonds have stormed higher - outpacing a wider market bounce-back from the initial Brexit rout.

MSCI's emerging equity index is set for its biggest weekly gain since March, while yields on debt denominated in emerging currencies such as rouble and the Brazilian real have fallen as much as 50 basis points over the week. (Graphic:http://reut.rs/2938RL0)(Graphic:http://tmsnrt.rs/298pvNd)

"Janet Yellen has made it clear that events outside of the U.S. will have a bearing on the Fed’s decision making and she was explicit about the risk that she thought Brexit would pose," said Viktor Szabo, Senior Investment Manager at Aberdeen Investment Management. "This pause from the Fed is going to support emerging markets."

Latin American currencies have been particularly well bid, with the Brazilian real near its highest level in almost a year, the Chilean peso at a one-month high and the Mexican peso on course for its best four-day streak since early 2010.

Underlining the renewed appetite for emerging market assets, Argentina announced on Thursday an offer of $2.75 billion in bonds, just three months after the country's historic return to the international capital markets.

Brazilian dollar bonds also saw strong investor demand with JPMorgan's index tracking the country's sovereign debt up more than 4 percent since Tuesday while Mexican debt has gained 3.8 percent.

The average yield premium demanded by investors to hold emerging debt over Treasuries has fallen by 30 basis points since Monday.

To be sure, the rally may not be sustainable. Brazil still faces record deficits and expects to remain in a recession next year while Mexico's peso had drifted to a record low against the dollar prior to this week's action. A set of particularly strong U.S. data might also rekindle Fed rate rise expectations, putting emerging currencies under pressure again.

But for now, investors like what they're seeing from these assets.

"Emerging markets are in a good place with 'one and done' Fed," Bank of America Merrill Lynch told clients, referring to the likelihood the Fed will not raise rates again this year.

YIELD HUNGER

Typically, the uncertainty triggered by an event like Brexit would prompt investors to flee riskier emerging market assets, but pessimists may have underestimated the positive effect of increased liquidity in markets.

A British flag flutters in front of a window in London, Britain, June 24, 2016 after Britain voted to leave the European Union in the EU BREXIT referendum. REUTERS/Reinhard Krause

Not only have markets effectively priced out a Fed rate rise this year, Bank of England Governor Mark Carney on Thursday signaled more policy easing to counter the negative economic effects of Britons' vote to quit the EU.

Expectations of further stimulus are also building in the euro zone, Japan and China.

Since the Brexit vote more than $1 trillion worth of bonds have joined the negative-yield club, with more than $11.7 trillion worth of debt worldwide now estimated to be yielding less than zero.

U.S. 10-year bond yields are just a whisker off record lows while the dollar's retreat is lifting emerging currencies, with Brazil's real moving below 3.20 reais per dollar for the first time in a year on Thursday.

The Mexican peso was on pace to gain more than 4 percent against the dollar since Tuesday, lifted partly by a half-point interest rate rise.

Local currency bonds, already among this year's best performing assets with gains of around 15 percent in dollar terms, are on a roll.

Here Latin America is benefiting less than other regions given interest rates look unlikely to fall - Brazil's central bank governor for instance said it was too early to cut rates.

But across emerging Asia benchmark 10-year bond yields have fallen between 20 and 40 basis points in the past week. Russian yields are at the lowest since February 2014 while South African yields fell to seven-month lows, down 50 bps in the past week.

"If you look at real yields in G4 they have fallen very sharply," said Unicredit strategist Kiran Kowshik, referring to the grouping of Britain, euro zone, United States and Japan. "And typically when real yields fall you tend to see a search for yield in emerging markets."

(Reporting by Dion Rabouin; Additional repoting by Sujata Rao in London; Editing by Tomasz Janowski)

[© 2016 Thomson Reuters. All rights reserved.]

Copyright 2016 Reuters. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.