Insight

The attractiveness of EM local market debt

The attractiveness of EM local market debt

After a difficult first half, now may be a good time to consider EM local bonds.

Several unanticipated shocks have upended global financial markets this year and strained economies already impacted by pandemic-related supply-demand distortions: Russia initiated a war in Ukraine, commodity prices spiked, and China slowed precipitously amid renewed lockdowns. 

These shocks have exacerbated existing inflationary pressures and forced global central banks, including the US Federal Reserve (Fed), to tighten monetary policy aggressively. The rapid repricing of inflation expectations and sharp rise in US interest rates has led to considerable market volatility. Most recently, the market has vacillated between inflation fears and the prospect of more aggressive rate hikes, to recession fears and the anticipation of lower interest rates. 

Against this backdrop, broad fixed income indices have declined this year, especially emerging market (EM) debt, which has suffered one of its largest selloffs since the 1990s even though bottom-up fundamentals are relatively sound. In many cases, higher commodity prices have been a tailwind for commodity-exporting countries, for example, leading to improved current account and fiscal balances. 

Although market selloffs are always painful, we believe it is worth noting that the asset class has faced significant drawdowns in the past, and each time, patient investors were ultimately rewarded (Figure 1). At this point, the value created in EM has been significant, in our view, generating a potentially attractive entry point for investors with a long-term perspective. 

Figure 1: Patient EM investors have typically been rewarded

Crisis Date JPM GBI-EM Global Diversified Return (%) Return one year later (%)
Global financial crisis 7/31/2008 11/30/2008 -22.15 35.62
“Taper Tantrum”, China slowdown 4/30/2013 9/30/2015 -13.19 17.06
COVID-19 12/31/2019 3/31/2020 -16.48 13.23
Hawkish Federal Reserve, Russia-Ukraine war 12/31/2020 6/30/2022 -15.44 ?

Source: Morningstar. The time frame for “Return one year later” is one year following the end-date of the corresponding period.

What do we expect going forward?

EM central banks are well ahead of their developed market peers in terms of their tightening cycles, meaning EM rates may be approaching their peaks. Several EM countries, such as Brazil and Mexico, have been hiking rates for more than a year. The impact of recent negative shocks also appears to be abating, which should allow Europe and China to post stronger growth in the second half of this year. The biggest shock to Europe is probably behind us, although if Russia completely cuts off gas supply, we could see another leg down in European growth. Because such a scenario would likely be met with enormous fiscal spending, we would expect a sharp downturn followed by a sharp upturn. While China’s recent growth numbers have disappointed, policy actions have gone into high gear, including rate cuts and loans to real estate projects. In EM, we expect the growth picture to remain stronger than in the US and Europe, where a growth revival could take some time.

Global inflation appears to be in the process of peaking, and it is encouraging to see the rate of change possibly stabilizing, although it could remain elevated beyond central bank targets for some time. While we expect the Fed’s messaging to evolve as new data come in, we anticipate global monetary policy to stay focused on fighting inflation and curtailing inflation expectations. 

Based on our growth, inflation and policy outlooks, we believe conditions are aligning for international fixed income to outperform over the next two to three years, led by EM. From a valuation perspective, EM offers a significant opportunity, based partly on the large interest rate differentials between EM and developed markets. While uncertainty surrounding the path of US interest rates has so far prevented investors from unlocking this value, we expect greater clarity on the Fed’s policy path in the coming months to resolve that.

The figures below show the value proposition of EM local bonds and their potential alpha-generating opportunities. 

Figure 2: Emerging market local bond yields are the highest in a decade
Figure 2: Emerging market local bond yields are the highest in a decade

Source: Bloomberg L.P. Data as of July 1, 2022. GBIEM refers to the J.P. Morgan GBI-EM Global Diversified lndex.

Figure 2 shows the weighted average of 10-year nominal EM yields versus US yields. EM local bonds currently yield around 7% on average, around 400 basis points higher than the yield on the 10-year US Treasury, a level not seen in over a decade. The recent negative performance in EM interest rates has resulted from EM central bank tightening beginning in 2021, resulting in bond price declines. But these policy decisions have led to the high nominal interest rates that are now available to investors. 

Figure 3: For the first time in a decade, EM inflation is lower than US inflation
Figure 3: For the first time in a decade, EM inflation is lower than US inflation

Source: Bloomberg L.P. Data as of July 1, 2022. GBIEM refers to the J.P. Morgan GBI-EM Global Diversified lndex.

EM’s value proposition is strengthened by a lower average level of inflation compared to the US (Figure 3), a phenomenon not seen in over a decade and rarely in combination with such high nominal EM yields. With global inflation potentially close to peaking, we believe EM yields are especially attractive in real terms.

Figure 4: EM currencies have performed well, even amid US dollar strength
Figure 4: EM currencies have performed well, even amid US dollar strength

Source: Bloomberg L.P. Data as of July 1, 2022. GBIEM refers to the J.P. Morgan GBI-EM Global Diversified lndex. WGBI refers to the FTSE non-US WGBI Index. Past performance is not a guarantee of future returns.

Some conventional thinking holds that EM currencies must underperform in periods of US dollar strength. Figure 4 helps debunk that notion by showing the relative strength of EM currencies over the past five years. During this period, US dollar strength has not been driven by EM currency weakness primarily, but by weakness in other developed market currencies. In the past year, the US dollar has appreciated on expectations that the Fed would hike more than other central banks. And the most recent leg of the US dollar rally has been driven by risk aversion amid the prospect of a looming recession in the US and Europe. We currently view the US dollar as overvalued and believe that, as world economies stabilize, the US dollar should depreciate.

Conclusion

We expect individual country dynamics to drive EM performance going forward, such as the impact of election outcomes and the effect of commodity price moves on importers and exporters. In the current challenging environment of tighter financial conditions and growth concerns, we believe considering individual country dynamics will help investors more quickly unlock value in EM than waiting for the market to ultimately shift its focus away from inflation concerns. We also expect the dispersion in returns among EM countries to be larger than in the past and believe that potentially diverse EM performance argues for an actively managed approach, such as ours. 

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