Significant long-term valuation opportunities can be found in emerging-market local-currency debt, says Liam Spillane.
- The underperformance of emerging markets in recent years reflects structural and cyclical headwinds
- Further volatility is a risk in the short term
- Notable signs of stability and improved competitiveness are now seen in some emerging economies
- The asset class currently offers exceptionally good value to long-term investors
Since 2011, emerging-market economies have experienced major currency depreciation and deteriorating terms of trade as commodity prices have fallen and global trade has slowed. Despite speculation to the contrary, emerging economies have, broadly-speaking, maintained their stability throughout this period. Moreover, a long and painful period of economic adjustment is having a positive impact on structural imbalances.
This major, multi-year adjustment has created significant long-term valuation opportunities, specifically:
• Emerging-market currencies have reached attractive long-term, multi-year valuations
• Local-currency bond yields are attractive relative to other asset classes and on an historical basis
• Current account balances in emerging markets are seeing significant improvement across a wide range of economies, though growth remains a challenge
Our emerging-market debt team identifies opportunities through an investment process that analyses macroeconomic, valuation, cyclical and technical factors with a clear and separate identification of foreign exchange (FX) and duration risk opportunities. Viewed through this framework, and given the multi-year adjustments highlighted earlier, the average inflation-adjusted FX depreciation of close to 20 per cent against the US dollar on an index-weighted basis represents a significant boost to competitiveness for some emerging economies. This is a major factor in the recent adjustment in structural fundamentals and as a result, our analysis indicates that a significant proportion of benchmark emerging-market currencies and local-currency bonds offer long-term value.
Pricing the risks
Notable short-term risks to the asset class include the path of the US dollar and a sustained slowdown in Chinese growth. However, our base case remains for a soft landing for growth in China and a gradual, managed depreciation of the renminbi. On a tactical time horizon, an improvement in the growth fundamentals in emerging-market economies would provide a significant boost to the outlook for the asset class. However, under certain market conditions, valuations are attractive enough to compensate strategic investors for these concerns. Following the recent rise in US interest rates, further clarity around the future path of US rates alongside a relatively stable US dollar would be a major catalyst for strategic opportunities, especially when factoring in the long-term structural improvements.
The long-term valuation signals in emerging-market local-currency debt are attractive and the asset class may deliver significant returns for investors on a medium to long-term basis. Despite the potential for short-term volatility, the long-term emerging-market story remains firmly in place and the asset class is supported by favourable demographics and productivity, as well as the relative stability of debt and reserve levels. The outlook for emerging markets can change quickly and the catalysts that indicate that it is time to increase exposure to local-currency debt may be much closer than some expect.