4 Reasons to Revisit EM Local Debt

Investors in local emerging market (EM) bonds have faced headwinds in recent years as factors such as US dollar strength, slowing growth in China and commodity weakness have put pressure on returns. But this year we have seen a revival in the emerging debt and currency markets as these pressures have eased. Investors have been returning to the market, motivated by the pull factor of stabilising EM fundamentals on one hand, and the push factor of low or negative developed-market interest rates on the other. We believe the time is right to re-engage with EM Local debt.

SOUND FUNDAMENTALS

EM fundamentals remain sound, with solid government balance sheets and higher growth profiles relative to developed markets. The growth differential between emerging and developed markets has stabilized, with growth in larger emerging economies such as China, Brazil and Russia steadying in recent months. As China continues to rebalance its economy toward domestic services and consumption, the country faces an ongoing structural downward growth trend that poses a risk to growth in Asia as well as in a number of other EM economies. But we anticipate a “soft landing” outcome for the Chinese economy, supported by looser fiscal and monetary policy.

REFORM TRENDS

reform is under way. A number of EM countries are undertaking reforms and difficult adjustments that should enhance economic growth in the future, and this should be supportive for their investment prospects. Political sentiment in countries such as Indonesia and Argentina, for example, has improved following recent elections. This has already led to structural reforms in these countries, and we expect the trend to continue. Amid market concerns about the long-term growth model of emerging market economies in general, countries that are undertaking structural reforms should benefit in relative terms from investor flows.

ATTRACTIVE YIELDS

From a relative value perspective, yields are more attractive in emerging market local debt than developed markets, where a growing number of securities are trading with negative yields. For example, Japanese government bonds in maturities up to 10 years now trade in negative territory. Duration is also shorter in the asset class compared with many other fixed income sectors, including developed market sovereign debt. Markets such as Mexico, Brazil, India, and Indonesia currently offer some of the most attractive local rates.

CURRENCY OPPORTUNITIES

On the currency side, the US Federal Reserve’s slow path of returning monetary policy to normal has boosted emerging market currencies. Although a potential Fed rate hike in December would create short-term headwinds for EM currencies, in our view they remain attractive in the longer term. The stabilization of commodity prices throughout the year has also benefited EM currencies relative to developed bond markets.

In summary: Against a background of improving sentiment and a recovery in commodity prices, we think local emerging market bonds continue to offer long-term investors an attractive yield premium over developed market bonds, and with less interest rate exposure.

2016-GL-5099