Five Reasons for Optimism In EM Local Currency Debt
It has not been a vintage year for emerging market debt. The JP Morgan GBI-EM Global Diversified index is down 14.5% in USD terms1 which, aside from 2015, makes it the worst annual performance since the index inception in 2002. The recent bounce in markets has seen EM debt swept higher as both risk assets and developed market bonds rallied. Much of the wider market move was thought to be the reduction of underweight or short positions as the lower than expected US CPI and signals that China is in the process of relaxing its Covid protocols, pushed against the negative asset market backdrop that investors have become accustomed to. There are questions on the durability of this rally but, in our opinion, there are several factors that should help sustain investor interest in emerging market debt.
Even though there has been a bounce back in EM debt, yields remain historically high. The yield to worst on the Bloomberg EM Local Currency Liquid index is at around 6.7%. This has come off peaks of over 7% but remains at its highest levels since the index was incepted in January 2010. A large part of the yield comes from coupons which saw returns for that index of 1.66% between the end of June and October 2022. This equates to an annualised running yield of close to 5%.
A key question for local currency exposures revolves around the fortunes of the USD. For year to the end of October 2022 just under half of the negative returns for the Bloomberg EM Local Currency Liquid index have been accounted for by currency. After plenty of false dawns where investors believed the USD had peaked, the fact that the DXY is currently around 6.5% off its September highs may provide some comfort that the peak to the USD is now in place. SSGA’s long term estimate of fair value puts the USD as 17.2% overvalued against the basket of currencies that make up the Bloomberg EM Local Currency Liquid index. If that strength continues to unwind as we move into 2023, that is a positive tail-wind for the performance of EM local currency assets.
Investors are thought to be underweight emerging market assets. From a fixed income perspective this can be seen in the latest edition of the Bond Compass. Local Currency fixed income flows for Q3 were estimated at around only the 10th percentile, so extremely weak relative to their 5 year history. Holdings were around their 25th percentile so also weak and indicative of underweight positioning. Repeated disappointment has unsurprisingly taken its toll on investor patience with the asset class, but this does indicate that there is substantial scope to rebuild EM debt holdings if sentiment improves.
It is well accepted that emerging markets are more risky than developed markets (DM) but, as we point out in the Bond Compass, perhaps the gap is narrower now than it has been for some time. It was most DM central banks that were late to start policy tightening in the face of rising inflation. Negative market events, such as the UK’s mini Budget, are also indicative of a world where perhaps there is less of a distinction between the two. While we remain far from a ‘risk-on’ environment, developments like the gradual relaxation of Covid rules in China could help to ease investor aversion to risk.
EM central banks were relatively swift in attempting to combat inflation pressures as can be seen in the EM central bank tracker which looks at the balance of those banks hiking rates in 20 EM countries. Having been on a relentless rising trend since Q1 2021 (well ahead of the BoE, the Fed and ECB) the number of central banks in policy tightening mode is now declining. Some banks have come to the end of their tightening cycle and if inflation starts to fall back and their currencies appreciate versus the USD, there may even be room to start easing policy.
Emerging markets have already put in a creditable bounce, with the Bloomberg EM Local Currency Liquid index making returns of 5.3% November to date. Year-end can be a volatile time, not least for the slightly less liquid corners of the bond world, but for those with an eye towards the types of strategy that could perform in 2023 then Emerging markets certainly has a considerable number of factors that could start to push in its favour. Even in the event of a fairly neutral backdrop for bonds and a steady USD during the early part of 2023, the high yields on offer from EM should provide some meaningful positive returns.
Emerging Market central banks coming to the end of their policy tightening phase
How to play this theme
Investors looking to access EM debt can do so with SPDR ETFs. To learn more about these funds, and to view full performance histories, please click on the fund names below.
1 Year to 16 October 2022, Source Bloomberg Finance L.P. 2 Prior to 1 February 2022, the Fund was known as SPDR Bloomberg Barclays Emerging Markets Local Bond UCITS ETF (Dist), tracking the Bloomberg Barclays Emerging Markets Local Currency Liquid Government Bond Index. 3 Prior to 1 February 2022, the Fund was known as SPDR Bloomberg Barclays Emerging Markets Local Bond USD Base CCY Hdg to EUR UCITS ETF (Acc), tracking the Bloomberg Barclays Emerging Markets Local Currency Liquid Government Bond Index unhedged USD base hedged into EUR. 4 Prior to 1 February 2022, the Fund was known as SPDR Bloomberg Barclays EM Inflation Linked Local Bond UCITS ETF (Dist), tracking the Bloomberg Barclays Emerging Markets Inflation Linked 20% Capped Bond Index.
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