Though the ongoing conflict in the Middle East is yet to show a significant impact on global projected growth, frontier markets like Sri Lanka face a challenging trading environment as they navigate an uncertain transition between inflationary shock and demand destruction, said PIMCO Emerging Market Portfolio Manager Yacov Arnopolin, speaking to Bloomberg television on Friday (20).

"What is probably not reflected yet is likely the hit to growth and potential demand destruction," Arnopolin said, commenting on the lack of substantial signs of the impact globally, in the long-term. "With that in mind, we are starting to see value in the long ends of curves in Brazil, South Africa and the Czech Republic," he said, noting that the market price of assets in these nations have over-discounted the negative impact, making them attractive for investment.

Meanwhile, he noted that emerging markets in Asia, particularly frontier markets like Sri Lanka and Pakistan, face a different reality when it comes to trading sovereign bonds and currencies.

"That is the toughest thing to trade in an environment where you have this uncertainty and we don't know how long this situation will last. The toughest thing to trade is a handover from the inflationary shock to demand destruction," he noted.

Sri Lanka's rupee traded at 311.50/80 against the US dollar on Friday, edging weaker from previous sessions as demand for dollars persisted. The currency has depreciated approximately 5.2 % over the past year, though it remains stronger than it was during the 2022 crisis low, when it reached 372/dollar.

Short-term Treasury Bill rates stood at 7.61 % for 91-day bills and 7.91 % for 182-day bills in mid-March, while longer-dated bonds traded at significantly higher yields, the 10-year yield at 10.82 % and the 15-year yield at 11.07 %.

Arnopolin explained that markets have already adjusted to expectations of higher interest rates, as short-term yields have spiked and traders have begun pricing in more central bank hikes. In Sri Lanka’s secondary bond market, yields initially spiked as Brent crude briefly touched $ 120 per barrel, then reversed as oil prices abated. Foreign holdings of Sri Lankan government securities recorded a net outflow of Rs. 4.50 billion during the week which ended 12 March.

"The curves have been flattened, we have priced in more hikes. In our view more hikes are likely to take place, or are justified because we are seeing demand destruction, we are seeing this in Asia as well because of regulating energy. Asia to us remains vulnerable. Asia is naturally a huge oil importer from the Middle East," he said.

"We are cautious about some frontier markets in Asia, Pakistan comes to mind, Sri Lanka comes to mind."

However, Arnopolin noted that though both economies faced defaults in the recent past, it is unlikely that the present situation will bring about the same economic consequences in the immediate run, cautioning that factoring in more risk premium would safeguard investments.

"It is a far cry from five years ago, we really were concerned about the defaults in both of those places. Pakistan, although a small, frontier economy reliant on oil from the Middle East, they have a bond repayment in a couple of weeks. I think they won't have issues paying that bond. It's a question of broader vulnerabilities and more risk premiums that should be priced into the longer part of the curve, and the same goes for Sri Lanka."

He noted that in more cautionary signs, India's rupee remains a concern. "When we look at our portfolio right now, we are quite cautious on currencies in India," he said.