Emerging markets local debt: Time to wade in?

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First caught in the crosshairs of the COVID-19 crisis, then roiled by the Russia/Ukraine conflict and the onset of global monetary tightening, emerging markets (EMs) have experienced their share of challenges and volatility over the past few years. Despite the recent turmoil (or in some cases, because of it), we think now is an interesting and opportune time to consider investing in emerging local debt (ELD) markets. As we survey today’s ELD landscape, we see potentially positive trends across fundamentals, valuations, and technicals that we believe are likely to be supportive of these markets going forward.

ELD markets have two primary sources of investment returns: interest rates and currencies. Let’s look at both and how they factor into our current outlook for these markets.

Interest rates

EM interest rates have faced significant upward pressure since the start of 2021. The post-COVID reopening of the global economy was accompanied by higher-than-expected inflation that has persisted through 2022, driven by a combination of labor shortages, supply bottlenecks, and abundant monetary and fiscal stimuli. More recently, Russia’s invasion of Ukraine and ensuing surges in food and commodity prices have pushed inflation (and rates) higher still. As a result, EM interest rates are currently in the midst of their largest, longest drawdown since the inception of the JPMorgan Government Bond Index-Emerging Markets Global Diversified (the Index) nearly 20 years ago (Figure 1).

Figure 1

Many EM central banks moved quickly to address inflation, well ahead of their counterparts in the developed markets. Sixteen EM central banks — out of 20 in the Index — have raised interest rates since the end of 2020. Twelve of those 16 have raised rates by more than 200 basis points (bps) over this period.¹ Meanwhile, the US Federal Reserve (Fed) and other developed market central banks are still in the early stages of their rate-hiking cycles. Typically, EM central banks do not ”front run” the Fed in this manner, so we see their proactive approach to addressing inflation this time around as an encouraging development.
The ongoing Russia/Ukraine crisis is likely to keep global inflation elevated, given its impact on commodities and food prices. This may extend the EM rate-hiking cycle over the near term, but as global economic activity begins to normalize from its post-COVID bounce, and as fiscal stimuli fade and central banks withdraw liquidity, we believe inflationary pressures should start to relent, giving EM policymakers greater latitude to stabilize rates before shifting to an outright easing cycle, particularly in light of the economic slack in many EMs.
Interest-rate valuations are, in our judgment, attractive following the recent sell-off. The yield on the Index rose by 254 bps from the end of December 2020 through June 2022, to 6.75%, its highest level in more than three years.² The yield gap versus the G3 (the US, Japan, and the euro area) has widened, confirming that EM rates have adjusted to inflation more quickly than their developed market counterparts. Even if EM central banks are unable to ease policy going forward, we believe the current level of yield provides attractive carry relative to developed market yields.

Figure 2

From a technical standpoint, significant asset flows have gone into emerging markets over the past several years, but most of those flows have favored hard-currency markets over ELD markets. Investor interest in the latter has been more muted, which at the least would suggest that local markets are not overly “crowded.”

Currencies

For EM currencies, we believe investors need to think about both the domestic drivers of potential currency strength in each market, as well as the outlook for the US dollar (since most EM currencies are traded against the greenback).
The US dollar (USD) has been in an extended bull run cycle for much of the past decade. As we look forward, there are a number of factors we can point to that would suggest that the cycle may be coming to an end: the growth of massive twin deficits in the US, the absence of a meaningful interest-rate advantage, and cooling economic growth as the effects of stimulus measures begin to wane. Another consideration, more technical in nature, is that the USD has historically often strengthened into the onset of a Fed rate-hiking cycle, but then once the Fed actually raises rates, the USD strength begins to weaken. As EM currencies trade in opposition to the USD, such periods usually tend to favor EM currencies (Figure 3).

Figure 3

On the EM currency side, although inflation is likely to remain elevated over the near term, we believe it should begin to subside as 2022 progresses and gives way to 2023. EM current accounts are largely in balance as of this writing, while the noted yield differentials between EMs and DMs are likely to provide EM currency support as well. For much of the period following the global financial crisis, broadly speaking, not only were global yields (including in EMs) close to historic lows, but EM currency weakness did not pass through to inflation, keeping most EM central banks on the sidelines. That dynamic has now clearly shifted, and with EM central banks having been relatively quick to respond to inflation “pass-through,” the ensuing policy-rate advantage should help bolster EM currencies over the medium term.
EM valuations in inflation-adjusted terms — based on nations’ real effective exchange rates (REERs) — have begun to correct toward their longer-term averages, but still remain well below the peak levels achieved during previous USD bear cycles. A turn in the USD, accompanied by improving EM financial conditions, should be supportive of EM currency strength over the near term.

Figure 4

How to think about Russia/Ukraine?

Clearly, the onset and continuation of the war in Ukraine have upended global markets and weighed on the EM asset class. Uncertainty about the ultimate outcome of the war, its impacts on global growth and inflation, and the potential for economic sanctions to be further extended against Russia and/or to other countries remain key risk factors to monitor. In the short term, we believe many EM central banks will need to keep hiking rates (or at least remain “on hold” for longer periods). Still, investors with longer-term time horizons might consider slowly adding duration exposure to their portfolios and perhaps revisiting underweights to EM countries that are furthest along in their hiking cycles. Overall, we like the potential risk/reward profile offered by EM currencies at this time, with preferences for commodity exporters in Latin America, Indonesia, and South Africa and commodity importers in Eastern Europe and Asia.

Risks to our outlook: When would ELD not perform as we expect?

Our views expressed herein would likely not materialize if global inflation were to continue to rise unchecked in the period ahead, forcing EM central banks into extended rate-hiking cycles and placing ongoing upward pressure on local interest rates. Any expansion of the Russia/Ukraine conflict to other countries could also weigh on investor risk appetites and result in a ratcheting up of economic sanctions, which in turn might put added upward pressure on both EM local interest rates and currencies. A deterioration of EM current-account trends or a flight to the perceived safety of the US dollar would also likely keep EM currencies at weak levels.

Bottom line

At the asset class level, our views on the fundamental, valuation, and technical outlooks for ELD markets are generally positive. The market headwinds posed by today’s geopolitical and macroeconomic risks, while potentially formidable, do not by themselves detract from our conviction that some investors may benefit from having some portfolio exposure to both EM interest rates and currencies.

¹Sources: JPMorgan, EM central banks, Wellington Management. | ²Source: JPMorgan.