Fixed Income Boutique
The US dollar had a wobbly start to the new year as it lost ground to most major currencies. This is good news for emerging market (EM) currencies as the health of the greenback tends to serve as a barometer for the attractiveness of investments in EM local currency debt. This is because, historically, EM local currency debt performs well in a benign or weak US dollar environment. However, this is only one part of the story and there are additional reasons why EM local currency debt will own the decade of “Roaring Twenties”.
The reason why EM local currency bonds have been relatively out of favor over the past 7 years is that we have had three periods of major US dollar strength. These have been in 2013, 2015 and 2018. As per the “dollar smile theory”, the US currency tends to appreciate against other currencies when the U.S. economy is extremely weak or very strong. So only one of the ends of the dollar smile is actually negative for EM. When things go really sour it's bad for all risk assets (not only emerging economies).
Therefore, a strong dollar is a problem only when it is not backed by solid economic growth in the US, which would normally spill over and drive demand for commodities and manufactured goods produced by emerging economies:
So, in light of the above investing in EM local currency debt is not only about making the most of an actual, or elusive, dollar weakness. EM local currency bonds also thrive when the dollar is stable or moderately strong out of relative economic strength.
While it might be too early to herald an era of prolonged US dollar depreciation, the currency has shown unmistakable signs of weakness and market expectations could lead to a continuation of this. Indeed, the global Covid reflation trade will be broad based, not just a US story. Twin deficits are growing alarmingly, whilst interest rate differentials no longer support the US dollar vs all comers. Global reflation will also positively affect the global trade momentum, which most emerging economies benefit from. For their part, emerging market currencies reflect the real demand and supply of real trade and financial flows, and they pay you a positive yield on top of it. So, if investors need a dollar hedge in the portfolio, or if they simply expect the dollar to be weak or to stay stable, EM local currency bonds are the no-nonsense option that will allow them to meet their investment objectives, yet work in line with their constraints.
Against this favorable background, it is time to debunk some of the myths that have been holding investors back from buying the asset class. There seem to be a set of endless excuses to justify why investors should always be particularly cautious with EM local currency bonds: not enough carry, too volatile, unanchored inflation expectations, downbeat commodities outlook, fear of a strong dollar, widening current account deficit, lack of fiscal discipline, excessive positioning – you name it.
First of all, emerging economies are anything but homogeneous. While all of the above “endless excuses” may be relevant, they rarely apply to the same countries at the same time for the same reasons. Cheap oil prices can be a serious problem for Colombia’s trade balance, or for the federal budget in Mexico, but it is a gift for the fiscal and external accounts of China, India or South Korea. A vigorous US economy can translate into a strong dollar and, potentially, weakens EM currencies. On the other hand, it will positively affect the global trade momentum, which most emerging economies benefit from. A trade war may create distortion in the global supply chain and at the same time generate opportunities for those who are not directly impacted.
Let’s get more controversial:
Now that the most important myths about the asset class have been debunked, the most pressing question that is weighing on investors' minds is: can we expect a tantrum-free decade allowing EM local currency bonds to deliver superior returns? Barring unknown unknowns that are, by definition, unpredictable, it is hard to expect a prolonged period of dollar strength, and of higher rates in developed markets, given the vast amounts of debt that developed economies will have to finance and refinance over the coming decades (not to say forever).
The EM local currency debt universe is a huge, deep and diversified market that no global investor can afford to ignore. Of course, this does not mean investors should buy them just ‘because it’s big’. Rather, the asset class should be seen as a valuable cornerstone offering a volatile – but diversifiable – high return in almost every portfolio.