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​

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