Emerging markets local currency debt has had a stellar run over the last two years, returning more than 30% cumulatively since its post-taper tantrum lows at the end of 2015. More remarkably though, has been the strong year-to-date return. In a world of rising core rates, the JP Morgan EM local debt index has outperformed other fixed income assets with year-to-date gains of 4.2%. It’s therefore easy to question how long this rally can continue, and indeed, if this is as good as it gets given a less accommodative monetary policy stance from developed market central banks. We still see room for further gains going forward, though the rate of return is likely to be measured from here for the following three reasons:
1) Growth matters more for EM local assets and this remains a tailwind in 2018
QE was not the predominant driver of returns for EM local debt during2013-2015. The sector underperformed other risk assets significantly over that period. There were a number of factors behind this, but arguably, the most significant was the deceleration in EM growth and trade over the period. This led to EM capital outflows and currency weakness, necessitating domestic monetary policy tightening in most local markets. As a result, EM local debt sold off close to 30% over the period despite the positive impact of QE in other sectors. Fast forward to 2018 and the backdrop has significantly changed. We are in the midst of a global growth rebound with EM growth having bottomed out in 2015. This is likely to remain well anchored in the coming months and as such, should be a positive tailwind for the sector going forward.
2) EM local debt offers value in a world of tight valuations
In a world of low nominal and real rates, EM local debt stands out as a value trade with the JP Morgan EM local debt index yielding 6%. Additionally, real rates remain elevated across most of the EM local debt markets, and with a benign domestic inflation backdrop, this provides some support to weather rising core rates. Moreover, the case is particularly strong for EMFX. Average EM REER is still well below the longer term average.
This valuation and yield combination should remain the driver of EM local returns for the rest of the year.
3) Technicals are supportive as investors are still underinvested in EM local currency debt
Although EM debt has been an increasingly popular trade among the investment community for the past year, the allocations have been increasing from a very low base post-taper tantrum. Latest Institute of International Finance estimates show that global investors remain underweight EM assets compared with pre-taper tantrum levels. Moreover, inflows have been biased towards hard currency sectors, while cumulative inflows to EMD local currency are still far from pre-taper tantrum highs. An additional tailwind for local currency debt is the currency sensitivity to equity flows which should remain positive as investors increase allocations with the EM growth rebound.
Therefore, there is room to run in the local currency rally and although developed market policy normalization will provide periods of volatility, we expect investors will be looking at those as opportunities to add to their EM local currency allocations.