LONDON, July 24 Foreign investors have made gains of some 10 percent this year on emerging market bond portfolios but now dread future gains being eaten into by an old foe -- food price inflation.
Billions have been pumped into emerging market bonds this year by investors looking for alternatives to western markets where yields are minimal or even negative, especially in Europe.
Analysts say one reason investors have bought into emerging market bonds -- and still expect further gains -- is that sagging global growth is seen bearing down on inflation, giving emerging economies scope for extensive monetary easing.
A sudden rebound in food prices, which often make up a larger share of Consumer Price Inflation baskets in poorer developing countries, has complicated this outlook.
Maize (corn) and wheat export prices jumped some 20 percent in the first three weeks of July over their June level, the United Nations' Food and Agriculture Organisation said last week. Wheat has risen 25 percent year-on-year.
However, weather-related grain price gains can also be vulnerable to swift falls. The effect of food price rises also varies greatly from one economy to another.
"There have been massive food price rises in the past few weeks -- before that happened, emerging market inflation had been coming down quite nicely," said Maarten-Jan Bakkum, emerging markets strategist at ING Investment Management.
"If food prices continue to rise, emerging markets look less attractive as a whole."
Higher food prices restrict policy makers' scope to cut interest rates to spur growth and raise the spectre of 'stagflation', where low growth accompanies high inflation and monetary policy is paralysed.
"One dynamic that is underpriced in the market is the implication of food prices," said Manik Nairan, emerging markets strategist at UBS.
"Wheat and sugar prices are spiralling higher and will constrain the ability of some emerging market central banks to ease monetary policy in a big way. If they do so, there are large risks to the medium-term inflation outlook."
Central banks in China and Brazil have cut rates several times this year to spur growth, by 56 and 300 basis points respectively. Central banks in other large emerging markets like South Korea, South Africa and Taiwan have also cut.
This has pulled investors into emerging debt in both dollars and local currency. Yields on local debt from South Africa to Mexico have hit multi-year or record lows, bringing dollar-based returns on the sector to almost 10 percent this year.
South African 10-year domestic bond yields have fallen below 7 percent, lower than in distressed Spain, and yields on euro zone titan Germany's 10-year debt are a paltry 1.25 percent.
JP Morgan estimates emerging fixed income assets have drawn more than $43 billion of investor cash this year.
Higher inflation brings currency risk for foreign investors and a further complicating factor is that local investors see their real return on a bond fall when inflation rises and seek higher yields to compensate. The erosion of real yields thus cuts bond demand -- and prices.
"Foreign investors don't care what rouble inflation is directly. All they care about is what the rouble does against the dollar," said Charles Robertson, global chief economist at Renaissance Capital, taking the example of Russia.
As long as the rouble is stable against the dollar, foreign investors won't lose anything on inflation in Russia, he said.
But they may still lose out when local investors seek higher yields and drive down prices, especially in countries like India, where local investors are dominant, versus countries like Turkey, where they make up 20-30 percent of the bond market.
While food prices are usually more significant for inflation in emerging markets, the effect depends on the composition of the consumption bundle in each country.
"Food prices are a big part of the CPI basket, more than 30 percent in China, India, Indonesia and also Russia," said Bakkum.
Not all emerging markets suffer equally. The share of food in Brazil's CPI basket is 23.2 percent, and a good local harvest may partly shield people from a global food price spike.
"The local harvest is still the prime determinant of local food price inflation," said Robertson. If domestic inflation is mitigated by domestic food supply, then this may leave monetary easing as a plausible policy option for Brazil's central bank.
Investors will favour emerging market bonds in countries like Hungary, the Czech Republic and Poland, where food is a relatively small component of the consumption bundle, he added.
Central European bonds have performed well in the past few weeks, despite rising food prices.
Beneath the headline figures of high maize and wheat prices, the extent to which the shocks of a drought in the American Midwest and floods in Russia should affect food prices more generally is questionable.
"In Asia, the staple is rice, there is no obvious reason why that has to go up," said Philip Poole, head of macro and global strategy at HSBC Global Asset Management.
Food prices are also highly volatile and it may be too soon to adjust monetary policy expectations. On Monday, a forecast of rain in the U.S. Midwest where it has been unusually hot saw maize and soybean prices tumble 2 percent.
"Prices have risen very fast since June -- if you jump 50 percent in four weeks, it's too much," said Christian Gerlach, co-manager of Julius Baer's commodity fund.