Fixed Income Boutique

Emerging market local currency bonds are rising from the ashes

Market Update

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”.

Only half of the “dollar smile” is negative for EM currencies

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:

  • 2013 was the year of the so-called taper tantrum when the monetary policy conducted by the Federal Reserve was suspected to have fallen ‘behind the curve’.
  • The move of 2015 was the consequence of a commodity crash amplified by the suspicion of a balance of payment crisis in China.
  • And the dollar tantrum of 2018 was entirely driven by the fear that the America First policy conducted by the Trump administration, would result in a massive repatriation of capital in favor of the US, leaving some highly-indebted emerging and frontier economies starved of dollar funding.

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.

EM local currency bonds are a no-nonsense US dollar hedge for global investors

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.

Fallacies abound about EM local currency bonds

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:

  • A large external account deficit is not necessarily bad for investors, it is even precisely what they look for when the US dollar is weak.
  • High inflation is exactly what investors in inflation-linked bonds hope for when an emerging economy is not completely dollarized.
  • An abnormally high carry should always raise eyebrows, as it is often a sign of uncertainty rather than value.
  • As for volatility, let us say it attracts way more attention than it deserves, because what people really care about is drawdown, rather than volatility. And, by the way, what is volatility without knowing what the correlation is with the other assets in your portfolio. They may be negatively correlated, improving strongly its prospective risk/return profile.
  • A high debt-to-GDP ratio can be irrelevant. Japan has a public debt-to-GDP ratio of more than 230% and it’s not a big deal. Nigeria’s is less than 30% and it is an issue. What matters is:
    • If the country can afford to service its debt without crowding out essential expenditures, like public investments.
    • The debt numbers that are usually reported are the gross liabilities of the country. But if the government or the central bank owns a lot of assets (e.g. sovereign wealth funds, net FX reserves), the actual debt-to-GDP number can be significantly lower. Who cares about Singapore's gross debt-to-GDP of almost 150% when assets are estimated well in excess of that?
    • If there is capacity and willingness to generate a budget primary surplus, should the level of indebtedness be or become an issue.
  • Positioning? It is the last resort excuse to use when pundits run out of rationale to explain a market move… and let’s not even raise the ‘fund flows’ that are lagging, rather than  leading, indicators of future performance.

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.