Interest in emerging market debt (EMD) is picking up meaningfully due to a favourable top-down environment for the asset class. Global growth is strong and widespread, inflation is contained, commodity prices are rising and liquidity remains abundant. Allocations to EMD Local Currency (LC) as opposed to Local Bonds (LB) have been relatively small over the past decade, but this is likely to change.
Investors become increasingly concerned about holding duration, with inflation picking up and central banks calling an end to the monetary easing cycle. Investors are also attracted to LC due to the potential diversification benefits of allocations to this segment, as well as the undervaluation of EM currencies.
Daniel Wood, Senior Portfolio Manager EMD Local Currency at NN Investment Partners comments:“Local currency has three main advantages over local bonds in the current market environment.
“First of all, the key advantage of LC over LB in the near to medium term is a much lower sensitivity to rising interest rates. The LC index, the JP Morgan Emerging Local Markets Index Plus (ELMI+), has an average maturity of just two months as opposed to a duration of more than five years in LB, represented by JP Morgan’s Global Bond Index – EM Global Diversified (GBI-EM GD). LC currently offers a yield of close to 4% compared to 6% on LB. However, we do not believe the additional 2% compensates investors for the inherent duration risk in a rising rate environment. We forecast that for the countries in the LB index, more than half will see a pick-up in inflation through the end of 2019. In addition, we forecast that ten of the countries’ central banks will begin hiking policy rates during this period, as opposed to only four that will be cutting. Higher policy rates should be supportive for LC as interest rate differentials begin to widen relative to developed markets.
“The second advantage is that LC enjoys a more favourable index composition. Firstly, there is a much higher weight in the LC index allocated to basic balance surplus countries. These markets enjoy natural appreciation pressure on the currency and insulate investors from much of the FX volatility associated with reversals in global risk appetite. Secondly, and in contrast, LB has a much higher weight allocated to twin deficit countries, and while they enjoy higher yields, they are also vulnerable to depreciation of their currencies from investment capital outflows. Lastly, the LC index is more widely representative of EM ‘thematic risk’ than LB due to the 17% weight attributed to China and India combined. Due to restrictions placed on trading local currency bonds in these markets the LB index has a 0% weight.
“The third and final advantage is that LC provides better diversification, which is particularly important in an environment where many investors feeling the strain of tight valuations, but are unwilling to be out of the market when global fundamentals are so strong. Although Sharpe ratios are slightly more positive for LB relative to LC over the period January 2003 to December 2017, these ratios reverse sharply in periods characterized by broadly rising global policy rates. Correlations between LC and spread products between January 2003 and December 2017 were also significantly lower than for LB and actually negative with respect to US High Yield. In addition, LC also tends to perform better during times of market stress, historically exhibiting lower drawdowns than LB.”
Daniel Wood concludes: “We believe that investors are significantly under-allocated to LC in the current rising rate environment. LC enjoys the benefits of minimal duration risks and low correlation with spread products, which we believe will be beneficial to investors in an environment of rising global rates and increased fears of higher global inflation. With monetary policy set to tighten and inflation forecast to rise across the emerging market universe, we believe that LC should be the preferred habit for investors exposed to emerging market debt in the coming two years and potentially beyond.”