Continuing to Ride the Emerging Market Debt Bounce-Back
Emerging market debt was one of our investment themes in the Q2 Bond Compass, as we saw scope for a bounce in risk assets as the crisis receded. The Bloomberg Barclays EM Local Currency Liquid Government Bond Index has returned 9.45% since the end of March 2020 in USD unhedged terms.1
Despite this strong bounce, less developed markets have struggled to completely shake off the pandemic. High COVID-19 infection rates in countries such as Brazil continue to cast a shadow over the wider asset class. Nevertheless, emerging markets are diverse and, while some continue to suffer, others have been more effective at containing the outbreak. Indeed, it is this diversity that makes emerging market debt local currency an investment theme for the longer run. We see three key drivers:
Yields: Yields are relatively attractive in an otherwise lower-for-longer yield environment. Returns solely accounted for by coupons were 2.38% in H1 2020 for the Bloomberg Barclays EM Local Currency Liquid Government Bond Index. The index now has a yield to worst of 3.67% (as of 15 July 2020), low by historical standards but considerably higher than anything available in developed markets outside of high yield bonds.
Positioning: Investors are still underweight emerging market debt based on State Street Global Markets data released in our upcoming Q3 Bond Compass. Uncertainties around the resurgence of COVID-19 and wider geopolitical issues have left investor holdings in the 22nd percentile at the end Q2 2020, up from the 15th percentile at the end of Q1 2020. As investors look for yield, this long-term underweight may gradually be reduced if markets remain stable and a recovery emerges more solidly.
Currency valuations: With yields lower, future returns are expected to be led by a rebound in currency. There have been some signs of recovery but the currency basket for the Bloomberg Barclays EM Local Currency Liquid Government Bond Index was over 7.5% undervalued versus the USD, according to calculations from State Street Global Advisors at the end of June 2020.
Focusing on stability and diversification: Looking for the Asian skew
The Bloomberg Barclays EM Local Currency Liquid Government Bond Index has performed well year to date, driven by the high allocations to Asian bonds. This is the only region to generate positive performance, lifted by strong gains from the Philippines, as the central bank there has slashed rates. Moreover, we know that several of the larger countries within this Asian exposure, notably South Korea and China, have been more effective at dealing with COVID-19.
The higher allocation to Asia in the index, relative to other index families (c. 48% versus c. 30% in the JP Morgan EM GBI indices), means a lower exposure to the Americas, where some of the worst performers have been and the pandemic looks harder to control, notably in Brazil. Lastly, exposure to Africa and the Middle East is split between South Africa and Israel. This diversifies away some of the drag from South Africa. So while emerging market debt remains a risk asset, the Bloomberg Barclays EM Local Currency Liquid Government Bond Index has been effective at reducing exposure to some of the poorest performers.
Still looking for currency upside but watching for a weaker USD for EUR-based investors
Overall, risk appetite is returning to the markets and this is feeding through to emerging markets. There are still plenty of risks at play, however, and a cautious approach to entering EM would be to focus on short duration hard currency exposure in the segment. That said, hard currency exposures will not benefit if emerging market FX shows any elastic tendency to spring back to a more favourable level against the USD, thereby suggesting greater potential upside to well diversified local currency-focused exposures.
Indeed, as the markets are more focused on the recovery, the safe haven nature of the USD has gradually been less sought after. It is a key driver of performance for emerging market debt local currency indices, but for non-USD investors it could hinder part of the total performance.
EUR-USD performance has been driven by monetary policy and fiscal support to help economies weather the impacts of the pandemic. As highlighted by Christine Lagarde’s slightly dovish statements at the ECB meeting, recovery speed remains highly uncertain and the ECB will use the full PEPP bond programme purchases. This was in line with market expectations and the EUR strengthened slightly.
The EUR has started its upward trend post the announcement of the EU Pandemic Fund, a topic at stake of the EU meeting over the weekend. Long-term EUR-USD forecasts vary from current levels of 1.14 towards the end of 2020 to 1.17 by the end of 2021, and 1.20 by the end of 2022.s
The annualised cost of hedging the EUR-USD with 1-month forwards was around 3% in December 2019 and is now around 0.8%. The cost of hedging this risk has significantly weakened over the course of the pandemic as the US Federal Reserve cut rates in March 2020 by 150 bps, making the ability to switch between EUR-hedged and unhedged emerging market debt exposure less of a performance concern.
State Street Global Advisors, in partnership with Bloomberg Finance L.P., has introduced a currency-hedging methodology new to the ETF market, hedging only the USD base currency return of the index to EUR. As of today it is the only such ETF with this feature, allowing investors to harness the full potential of emerging market debt local currency in 2020.
Since the end of Q1 2020, and the recovery of emerging market debt local currency indices, this index has helped performance for EUR-based investors to be 9.07%, saving 3.9% against an appreciating EUR-USD.
If longer-term forecasts of a generally weaker dollar play out, this could support emerging market assets. Having the ability to hedge this risk could also greatly help EUR investors.
Figure 1: Rebased index performance in EUR vs. EUR-USD evolution