PMC Weekly Review - June 15, 2018
A Macro View: Every Rose Has Its Thorn: The Case for Emerging Markets Local Currency Debt
As volatility has returned to global financial markets in the first half of 2018, emerging markets debt, one of the strongest-performing fixed income asset classes over the past two calendar years, has been one of the hardest-hit segments of the bond market. The local currency segment of the market ( bonds denominated in the issuer’s local currency rather than those which are externally funded in more commonly used currencies such as the US dollar or euro) has taken the brunt of the blow in the second quarter, with the JPMorgan Government Bond Index-Emerging Markets (GBI-EM) Global Index down 9.03% June 13 (-4.99% year to date). This week, the combination of a strong dollar, a hawkish Federal Reserve, and disappointing economic data out of China has driven emerging markets currencies to a new 2018 low.
Despite the difficult recent performance, nearly all of the non-US fixed income managers we work with, including dedicated emerging markets debt managers and global fixed income managers who may allocate to those markets, maintain a positive outlook for emerging markets local debt. This view dates back to 2015, following several years of sharply negative performance due to a strengthening dollar and the unwinding of quantitative easing in the US. In fact, several of our global bond managers currently are allocating nearly half their portfolio to emerging markets local bonds and currencies, and many dedicated emerging markets managers are well above their historical average allocations to local markets. The variety of factors that can influence this asset class makes it useful to evaluate emerging markets local debt through three different lenses: credit fundamentals, valuations (for both bonds and currencies), and technicals (or market supply and demand dynamics).
From a fundamental standpoint, the asset class as a whole is on solid footing. Aside from a few problem children—Argentina and Turkey are two nations that have made negative headlines recently—most emerging markets countries are benefiting from steady global economic growth with generally low inflation, a widening growth differential relative to developed markets (which should attract capital investment), and stable or increasing commodity prices. At the same time, most emerging markets central banks have been acting with prudence, aggressively hiking rates to combat inflation when appropriate, and maintaining a surplus of foreign currency reserves, which can be used either to repay external debts or intervene if their currencies come under pressure. Although risks to the fundamental outlook exist, such as protectionist trade policies, the most widely held base case is for emerging markets credit fundamentals to remain broadly positive.
Valuations, which are stretched across nearly all fixed income sectors, are also more favorable in emerging local debt markets. Breaking down the asset class into its two investible components—interest rates and currencies—illustrates that local rates could be close to fairly valued, as many countries have already gone through a rate-cutting cycle, along with a fair amount of spread compression over the past two years. However, the income component is still compelling at a yield to maturity of nearly 6% for the JPMorgan GBI-EM Global Index, and relative to other fixed income sectors, such as US investment grade and high yield corporate credit, valuations are fairly attractive. Emerging markets currencies, on the other hand, remained undervalued coming into the year, still recovering from several years of depreciation against a strong US dollar (dating back to the taper tantrum in 2013), and are becoming more attractive due to the dollar’s renewed strength in the first half of this year. However, many of our asset managers view this as a short-term headwind and see a more moderated dollar over the medium term.
Market technicals are a bit more mixed, as emerging markets assets typically benefit in a risk-on environment, which has generally not been the case so far this year. Emerging markets debt, in general, is highly susceptible to asset flows and investor demand, which can be largely dependent on the market’s view of risk. However, one benefit of emerging markets local bonds versus those denominated in external currencies, such as the dollar or euro, is their tendency to have a sizable investor base of local institutions (who are long-term investors), such as pensions, which makes local currency debt less vulnerable to asset flows. The supply side of the equation is fairly positive, as debt issuance has been mostly stable, and debt-to-GDP ratios of emerging markets countries are a fraction of those of their developed market counterparts.
Though local emerging markets bonds currently make for an attractive investment opportunity, they are certainly not without risk. In addition to the added volatility foreign currency exposure introduces to a portfolio, other factors, such as the introduction of protectionist trade policies by the world’s largest economy, other geopolitical risks, and a heavy election calendar across many emerging markets countries, warrant caution. Given the risky nature of emerging markets, a key emphasis of the managers we speak to is taking selective exposure to the asset class rather than a pure beta approach, by focusing on fundamentally sound countries with positive reform stories and avoiding the more troubled countries. In addition, the ability to tactically hedge currency exposure or invest solely in the currency rather than the bonds also can be a means of generating excess returns. For these reasons, Envestnet | PMC strongly advocates for actively managed exposure to the asset class. Despite the risks involved, solid credit fundamentals, compelling valuations, and attractive real yields across global bond markets should provide long-term investors who can stomach the volatility with a diversifying source of attractive returns within their portfolio.
David Hawal, CFA
VP, Senior Investment Analyst
The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this weekly review is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results.
Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet|PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.
Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.
Alternative Investments may have complex terms and features that are not easily understood and are not suitable for all investors. You should conduct your own due diligence to ensure you understand the features of the product before investing. Alternative investment strategies may employ a variety of hedging techniques and non-traditional instruments such as inverse and leveraged products. Certain hedging techniques include matched combinations that neutralize or offset individual risks such as merger arbitrage, long/short equity, convertible bond arbitrage and fixed-income arbitrage. Leveraged products are those that employ financial derivatives and debt to try to achieve a multiple (for example two or three times) of the return or inverse return of a stated index or benchmark over the course of a single day. Inverse products utilize short selling, derivatives trading, and other leveraged investment techniques, such as futures trading to achieve their objectives, mainly to track the inverse of their benchmarks. As with all investments, there is no assurance that any investment strategies will achieve their objectives or protect against losses.
Neither Envestnet, Envestnet|PMC™ nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.
© 2018 Envestnet. All rights reserved.