(Bloomberg) -- One of the most-profitable trades across emerging markets this year is quickly losing its appeal.
An index of local-currency bonds from developing nations is dangerously close to erasing its gains for the year after a 2% drop in September put it on track for its worst month since February. Now HSBC Bank Plc and Goldman Sachs Group Inc. are turning more cautious on the asset class, which lured traders early this year amid easing global inflation and prospects for interest-rate cuts.
HSBC made a complete U-turn on emerging-market local debt this week, cutting its recommendation to underweight from overweight on the back of expectations for higher-for-longer interest rates in the US and a stronger greenback. Goldman Sachs said the premium between local and hard-currency notes has vanished.
Local government bonds were up more than 4% at one point in 2023 as investors rushed into the trade expecting sizable easing cycles after inflation slowed. But instead, the room for policymakers to cut may be narrower than expected as the Federal Reserve keeps rates elevated and high oil prices threaten the fight against rising consumer prices.
That dynamic has “complicated EM local” assets, according to Caesar Maasry, Goldman’s head of emerging-market cross-asset research.
“The rates cushion between EM and US has exhausted,” he said.
What’s more, Maasry said the premium between local-currency debt maturing in five years and dollar bonds issued by those same emerging economies has disappeared. “And that’s a problem,” he added.
The selloff hasn’t been confined to local rates. Developing nation assets had a dire third quarter amid increased volatility sparked by concerns about China’s economy and US interest rates. A broad gauge for stocks erased 2023 gains, and a similar index for currencies significantly trimmed its advance.
Read More: Emerging Markets Await Pivotal Quarter With 2023 Bets in Ruins
While some on Wall Street like Pacific Investment Management Co. have remained optimistic, Maasry said “it’s too early” to be more broadly bullish. He’s been telling clients to favor relative-value trades, betting on Korean equities versus Australia’s, and EM stocks ex-China versus Europe’s. He also likes the Middle East because of the oil rally. Within currencies, Maasry favors the Brazilian real and the Colombian peso versus the Chinese yuan.
“It’s more tricky here to be bullish on the EM tactically,” said Maasry.
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