Lauréline Renaud-Chatelain, Pictet Wealth Management.

We believe that extra carry and currency appreciation against the US dollar could lead to improved performance from emerging-market (EM) local-currency bonds.

Unlike most of their developed-market counterparts, to fight inflationary pressures many emerging-market central banks have already started to reverse last year’s policy easing. Rising inflation coupled with rate hikes and expectations for more to come have pushed many EM local-currency bond yields higher and prices lower.

The US dollar’s appreciation against EM currencies has exacerbated the negative year-to-date performance of EM local-currency sovereign bonds. However, early policy tightening by a number EM central banks and fast-improving vaccination coverage, coupled with some EM countries’ status as important energy exporters, suggest a number of EM currencies could appreciate against the US dollar, boosting the returns for their local-currency bonds.

We expect local-currency EM sovereign bond yields to rise further by the end of the year. This is based on our belief that EM central banks will hike rates more than is being currently priced in by market participants due to accelerating inflationary pressures. Nonetheless, relatively comfortable carry could compensate over time for the rise in EM bond yields and drop in bond prices.

Believing we could see their fortunes improve in the coming months, we have moved from underweight to neutral on EM local-currency sovereign bonds. We are not yet expecting particularly large positive returns--despite a relatively high carry, many real government bond yields are still low. But EM bond yields are at least mostly positive, unlike the negative real yields prevalent in DM sovereign bond markets.

Timing a reversal in the performance of a financial asset is always hazardous, and even more so in the case of EM government bonds in local currency given the exchange-rate component. However, our belief that we could see a change in their fortunes has prompted us to move from underweight to neutral on EM local-currency government bonds. While not expecting particularly large returns, we believe their performance could improve on the back of comfortable carry and currency appreciation against the US dollar.