Emerging Signs of Inflation
Emerging market (EM) local currency debt has had a strong run since April 2020, although the asset class seemed to hit the buffers in August with gains from the ongoing weakening of the USD and coupon flows being offset by falling fixed income prices. It’s fair to say that August was not kind to government fixed income generally but the lack of performance from EMs has been disappointing given the risk sentiment backdrop. From a historical context, the Bloomberg Barclays Emerging Markets Local bond index is 79% correlated with global high yield against just 29% for US aggregate, which largely consists of US Treasuries1. In other words, it behaves far more like a risk asset than a risk-free rate.
Times have changed, however, and investments are now all scrutinised through a COVID-19 lens and, in this respect, EMs have not fared well. With a limited ability to protect workers and businesses in the same way that developed nations can, many economies have reopened only to see a surge in infections.
In addition, many countries are undergoing an inflation surge on the rebound in oil and as currency depreciation seen earlier in the year manifests itself in higher import prices (see the State Street Global Markets publication, EM Inflation in Focus: Higher EM, Lower Asia). This certainly has the potential to bring to a halt to policy easing in some parts of the EM complex.
That said, from the perspective of being a yield enhancer and a risk diversifier, we continue to view EM as an essential part of any portfolio allocation, and there remain several factors that still support EM debt:
- Despite its recent declines, the USD still looks 10% overvalued against a basket of EM currencies, according to the State Street Global Markets fair value indices. We expect the USD to continue to weaken and this could support rising EM valuations as their currencies appreciate.
- The search for yield is a powerful investment driver. Yield is scarce in the current environment but the Bloomberg Barclays Emerging Markets Local Bond Index provides 3.6%2 without taking substantial duration risk. The ongoing compression in spreads on high yield naturally means that EM becomes a more interesting alternative.
- EM endured substantial outflows during the market turmoil earlier this year but evidence suggests that the flows have reversed. Flows into ETFs have been positive since April 2020 but picked up pace in June and July with net inflows of $2.1 billion and $1.8 billion, respectively. July also saw strong positive inflows into EM investment funds generally (active and passive) with over $5.4 billion coming into the sector.
Risk Reduction Strategies: Focus on Asia
Concerns about weak growth and a resurgence in inflation in some EM nations are real. The countries identified as most at risk of rising inflation by the PriceStats® indicators are those outside of Asia, with Turkey and three Latin American countries (Brazil, Colombia and Uruguay) deemed the most at risk. The geographical focus of the Bloomberg Barclays Emerging Markets Local Bond Index reduces these risks with a large allocation to Asia (48.7%) compared to 30.5% for the JP Morgan EM Local Government Bond Index. This means relatively less weight to the Americas, with no exposure to Uruguay and a combined 11.2% to Brazil and Colombia (the JP Morgan index has 15.5%). Finally, the weighting of Turkey is light at just 1.7%.
Additional Inflation Protection
For those still wary that the near-term inflation surge will prove detrimental to EM debt, there is the SPDR Bloomberg Barclays EM Inflation Linked Local Bond UCITS ETF. Aside from a divergence in 2019, the index tracked by this ETF has typically displayed the same inverse correlation with the USD that nominal debt does. The chart below shows the index plotted against the inverted value of the DXY (trade-weighted USD) and it does highlight the tendency of the index to push higher on USD weakness. So even though it is inflation proofed, it still behaves in the same way as a local currency fund.
EM Inflation-Linked Index Has Typically Moved Inversely to the USD
In terms of its geographical distribution, the inflation-protected index fits well with Bloomberg Barclays Emerging Markets Local Bond Index. It has low exposure to Asia (3.7%), where we view inflation as being less of a threat and where the Bloomberg Barclays Emerging Markets Local Bond Index is heavily exposed. Conversely, it is 42.5% allocated to the Americas and 16% to Turkey, where we believe inflation pressures are the strongest and therefore fixed income portfolios the most in need of protection.
Lastly, the Bloomberg Barclays EM Inflation Linked Local Bond Index has enjoyed a bounce, returning around 1% over the past month, but year-to-date performance remains well short of the nominal local currency index. A regression of the EM Inflation Linked Index against the nominal Emerging Markets Local Bond Index suggests the inflation index remains close to 10 points cheap to the level implied by the local currency index.3 If flows continue to come into EM debt funds then there is certainly scope for the inflation-linked index to play catch-up.
How to play this theme
Investors can play the emerging market debt theme described above with SPDR ETFs. To learn more about the fund, and to view full performance history, please follow the links below:
SPDR Bloomberg Barclays EM Inflation Linked Local Bond UCITS ETF
European-Domiciled ETP Segment Flows (Top/Bottom 5,$mn)
European-Domiciled ETP Asset Category Flows ($mn)
Sources: Bloomberg Finance L.P., for the period 27 August – 3 September 2020. Flows are as of date indicated and should not be relied upon as current thereafter.