Emerging market local currency debt potentially offers value despite recent rally
Despite a strong rally in emerging-market local-currency debt this year, a widening yield differential with US rates points to the long-term value of the asset class, says Liam Spillane.
Emerging-market local-currency debt has rallied in 2016, supported by the dovish stance of central banks across the globe and, in particular, the Federal Reserve’s apparent commitment to increasing rates gradually. A more balanced medium-term outlook for the Chinese economy, and greater stability for the US dollar and commodity prices, has also highlighted the attractive long-term value in local-currency assets, which we identified in a previous article on this topic in Januaryi. Long-term investor inflows into the asset class have picked up notably in recent months.
Evidence of this recovery can be seen in the performance of the JP Morgan GBI-EM Global Diversified index, the widely-used benchmark that we manage against and which tracks liquid local-currency government bonds and currencies. The index fell significantly in late 2015 and the first half of January this year as a result of global market volatility. By 20 April, the index had increased by around 13.5 per cent in euro terms and almost 18 per cent in US dollar terms from the lows seen in mid-January.
The pick-up of emerging-market debt relative to developed markets is perhaps a more relevant indicator of the remaining significant opportunities for long-term investors. At end April 2015, for example, the nominal yield differential between local-currency emerging-market bonds and US rates was around 4.4 per cent. That differential has since grown to about five per cent. We believe the current macroeconomic backdrop provides an environment for the asset class to continue to outperform if stable commodity prices persist and US monetary policy remains supportive. As a result we are currently positioned overweight in terms of both duration and foreign exchange. However, the need for differentiation on an actively managed basis across local-currency markets remains firmly in place. Currently, we have overweight positions in Mexico, Poland, Brazil, Russia and Indonesia, and underweight positions in Thailand, Hungary and Turkey in our local currency debt portfolios.
Pricing the risks
An improvement in external macroeconomic factors such as the stability of the US dollar and commodity prices has largely driven the rebound in local-currency markets since January. However, and more recently, there are tentative signs that the outlook for cyclical domestic economic fundamentals across the economies in the investable local-currency universe may also be stabilising and possibly even improving. This follows many years of deterioration and we would still suggest a degree of caution at this stage. However, as we also pointed out in January, if the recent stability can at least be sustained, this will potentially be another significant tailwind for the asset class. Moreover, we believe that if external conditions remain supportive the asset class should continue to perform well. We will monitor the recent cyclical fundamental improvement for further positive signals. Despite the potential for further periods of volatility, the long-term emerging-market story remains firmly in place and favourable demographics and productivity, as well as relatively stable debt and reserve levels, support the asset class.
i Opportunity knocks for Emerging-market local-currency debt, January 2016
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 21 April 2016. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and can fluctuate in response to changes in exchange rates. An investor may not get back the original amount invested.
Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
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- The asset class has rallied strongly following the lows reached in January
- Stabilising commodity prices, dollar weakness and heavy inflows from yield-hungry investors drove the upturn
- We continue to identify opportunities for long-term investors
- A selective approach is important given short-term risks and challenging fundamentals
- Overall, the long-term emerging-market story remains intact