Emerging markets debt perspectives: Shop local
Despite recent volatility in global rates, the U.S. Federal Reserve Board (the Fed) and European Central Bank (ECB) confirmed they are in full “data dependency” mode as they approach peak rates; meanwhile, the Bank of Japan continues to act as a handbrake for global rate volatility, exiting their Yield Curve Control policy in the most gradual way possible.
Emerging markets (EM) local debt has been one of the top-performing asset classes in 2023, returning 7% year-to-date through 17 August, with the vast majority of that performance coming from rates, as opposed to foreign exchanged (FX) appreciation. Given this year’s rally, and recent rate volatility, we revisit the prospects for the asset class over the short- to medium-term:
Bottom line up front (BLUF): We believe local markets have more room to run – despite the 7% year-to-date rally. Given recent performance, and the current stage of the market cycle, selections will be particularly important as inflation trajectories diverge and market pricing of rate cuts across several countries are realized. We continue to favor countries with high real rates and markets where central banks act preemptively (and aggressively e.g., Brazil and Mexico) or where disinflation is happening faster than expected (e.g., Hungary, Uruguay, Kazakhstan, and Uganda). Structurally, we continue to favor a more diversified set of markets due to varying economic cycles across regions and countries.
Going with(out) the flow: This year’s performance is notable given that it occurred without the accompaniment of substantial inflows – year-to-date net flows are essentially flat. Allocations to local markets remain on the lower end of the historical range due to the dollar’s fierce uptrend from 2021-2022. We believe this clean technical picture should provide a tailwind and further support the asset class into the latter portion of 2023 and beyond.
Don’t get carried away: One recent concern in the market is that emerging markets central banks’ rate cuts reduce their relative rate buffer to G10 – leading to potential emerging markets debt FX (EMFX) depreciation. However, we’ve found that history indicates the opposite – that rate cuts have only catalyzed more portfolio inflows as more investors take advantage of the cutting cycle. EMFX performance is not just about carry.
Fundamentally, EMFX is not only supported by high real yields, but improving balance of payments and resilient growth (vs. developed markets). Since 2015, we’ve seen structural improvements in EMs’ current accounts; meanwhile, supply chain diversification has led to improved net FDI flows to select EM ex-China. While we continue to view the dollar as overvalued, we recognize that it could benefit in periods of risk aversion. That said, we see the unwind of quantitative easing (QE) as a potential catalyst for a weaker dollar along with higher yields in Europe and Japan that can trigger some repatriation.
Policymaking, like EM, is not monolithic: Unlike previous hiking cycles, EM central banks have exhibited more orthodox policymaking than many of their developed market counterparts. They’ve preemptively responded to inflation with earlier and more substantial rate hikes. Coupled with improving current accounts (i.e., improved savings), higher interest rates have incentivized domestic investors to keep money onshore and invest locally. Even as rate cuts are being priced in, faster than expected disinflation in many markets are keeping relative real yields attractive. At this stage of the cycle, selections and a diversified portfolio will be even more important as inflation trajectories diverge and market pricing of easing in some countries becomes more realized. And of course, while many countries have elected for orthodox policy, this is not universal and macro fundamentals can vary quite drastically across emerging markets.
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