Heading into 2020, we continue to expect emerging market (EM) local currency debt to perform well relative to other strategies. With a potential phase one trade deal on the horizon, a mix of supportive factors could help to drive EM debt:
- Economic growth differential as EM countries are expected to rebound at 4.6% growth in 2020 versus 1.7% for developed economies.
- Accommodative global central bank policies pump liquidity back into the system
- Weaker inflation leads to increased real yield differential, supporting investor flows
- EM currencies undervalued versus the USD – currently c. 5.6% undervalued for the Bloomberg Barclays EM Local Currency Liquid Government Index.1
Of all of these factors, currency is most complex. Hedging EM currencies remains onerous as the short rate differential versus EUR remains quite high (4.1%).2 Logistically, over 50% of the index is only accessible via non-deliverable forwards, which need to be collateralized under EMIR regulation.
A weakening USD has historically led to flows into EM Debt. Moreover, in recent months market commentators have begun calling time on the era of USD strength. But a weaker USD potentially affects a EUR-based investor. For this reason, we believe investors could stand to benefit from hedging against a potential weakening of the USD versus the EUR while capturing the EM currency appreciation versus the USD.
The EUR-USD short rate differential is around 2.7%.3 Thinking in terms of insurance costs, this equates to a 0.23% monthly premium to hedge against a potential move of more than 5% in the EUR-USD pair. Based on the State Street Global Advisors currency valuation model, at 1.10 the EUR was c. 11% undervalued versus the USD on a long-term basis.
SPDR, in partnership with Bloomberg, has introduced a currency-hedging methodology new to the ETF market, which hedges only the USD base currency return of the index to EUR. As of 5 December 2019, the SPDR Bloomberg Barclays Emerging Markets Local Bond UCITS ETF is the only such ETF with this feature, allowing investors to harness the full potential of EM local currency debt in 2020.