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.