Two years of challenged returns, and high volatility, by emerging-markets local currency debt has prompted questions from investors. Is emerging-markets local currency debt still a valid asset class? How will factors such as lower commodities prices and changes in the U.S. Federal Reserve’s policy rate affect such debt? What is its market outlook? These are sound concerns, to be sure. But none of them alter our view that the asset class remains as legitimate as ever.
Multiple factors, including weaker-than-expected growth, capital outflows, heightened foreign exchange volatility and geopolitical tensions, have contributed to the poor performance of local currency–denominated emerging-markets debt — particularly the forex component of returns. The halving of the market price of oil in the second half of 2014 created further concerns. We believe, however, that this constellation of factors is unlikely to reoccur in the same way or with the same intensity. At current valuations, emerging-markets local currency bonds are set to outperform other fixed-income segments.
Issues like the decline in commodity prices are actually worth looking at more in detail. Emerging markets are often perceived as highly commodity-dependent, but the actual interplay between commodities and emerging-markets currencies — and, by extension, local currency debt — is nuanced. There is a diversity of commodity exposures within developing economies. Some countries are net exporters; others are net importers. For example, the countries in the J.P. Morgan GBI-EM Global Diversified index are on average net oil importers at a level of about 0.75 percent of GDP, despite the inclusion of major oil producers such as Colombia, Malaysia, Mexico, Nigeria and Russia. Thus, on an index level, lower oil prices tend to benefit the asset class economically. There is a similar correlation between emerging markets and other commodities.
Investors are also questioning how the asset class may behave in a rising interest rate environment, especially given the turbulence during the so-called taper tantrum in 2013. Local currency–denominated fixed income is in a much better position now. Market positioning in the sector appears to favor emerging-markets currencies, as investors have purchased U.S. dollars. As a result, we believe that the market volatility that resulted from the Fed’s initial discussion of normalization of monetary policy in May 2013 is unlikely to be repeated when the Fed actually begins raising rates. The impact of rising rates could vary meaningfully across countries within the asset class; some have eased monetary policies over the past two years to spur growth, whereas others have hiked rates to offset inflationary pressures or support their currencies.
There is a historically wide yield spread today between countries at either end of the spectrum of these diverging policies. This disparity leaves some countries’ rates markets much less vulnerable to rising core yields than are others. Some investors may believe that despite positive dynamics, the poor performance and heightened volatility of emerging-markets foreign exchange have undermined the validity of emerging-markets local currency debt as an asset class. We believe this view is misguided: It is precisely this volatility that creates attractive risk premium in the sector. When coupled with generally sound fundamentals, volatility generates investment opportunity. That was the case in 2009 and 2012, when sharp declines in emerging markets were followed by more significant recoveries.
The recent underperformance of emerging-markets local currency debt has led to value creation, especially for investors who are funded in U.S. dollars. Using the J.P. Morgan GBI-EM Global Diversified index as a guide, the real effective exchange rate of emerging-markets currencies has declined by 12 percent since the end of 2010.
Overall, we believe the outlook is good. There are scenarios that could darken the outlook and constrain investor appetite, however. The U.S. dollar could continue to appreciate, China could experience a more pronounced slowdown, commodity prices could drop dramatically further, or geopolitical tensions such as those in Russia and the Middle East could escalate.
Local currency–denominated emerging-markets debt is projected to generate about 6 percent returns in 2015 and 7 percent annual returns over a three- to five-year cycle. Over the long term, the yield differential between emerging-markets and developed-markets debt is expected to compress and return to historically normal valuations. The prospects for emerging-markets growth and improved valuations make a strong case for this asset class.
James Craige is the head of emerging-markets debt at Stone Harbor Investment Partners in New York. The Stone Harbor emerging-markets debt team contributed to this article.
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