Local currency and hard currency emerging market government bonds have partly recovered since the lows of the COVID-19 crisis, but Colchester Global Investors believes there is still value to be found in these emerging market fixed income asset classes.
Colchester has been holding a number of conferences on Emerging Market sovereign debt to give investors a better understanding of the key differences between the main asset classes within this space, namely hard currency and local currency denominated debt. The response from investors has been heartening and we share with you some of the key questions investors have been deliberating over, and the thoughts of Colchester’s investment team below:
Yields are rising in the US, what does this mean for Emerging Markets?
Emerging market assets have weakened since the turn of the year with rising yields in the US weighing on local and hard currency bond prices and some depreciation of EM currencies against the US dollar. Rising yields do equate to a tightening of global financial conditions all else being equal, and a strengthening US dollar is often associated with a reversal of capital flows to EM as we observed with the “taper tantrum” in 2013. Nonetheless, we at Colchester believe the current period is not comparable to 2013, for a few reasons:
- The rise in US yields can largely be attributed to the more positive outlook for the US and global economies, and an associated rise in inflation expectations;
- Real yields in the US remain close to historical lows, and remain a “push factor” for capital to seek out the more attractive real yields of the Emerging Markets;
- There is no indication of monetary policy being tightened in the US; and
- The external balance sheets of emerging economies are generally stronger than in 2013, for example more robust current account positions in many cases and a lower reliance on portfolio inflows.
Real exchange rate valuations of many of the major Emerging Markets have improved relative to those prevailing in 2013, as exchange rates have weakened materially in nominal and real terms since then. With external vulnerabilities having significantly reduced since 2013, this puts many of the Emerging Markets in a much stronger position today to withstand tighter global financial conditions. We see opportunities to take advantage of undervalued currencies, combined with robust external balance sheets and credible policy frameworks.
EM currencies have weakened for many years, why don’t you think they will continue to depreciate?
The consistent undervaluation of EM currencies in recent years is indeed striking, but does not in itself shift our opinion that such undervaluation will eventually be corrected. In the short term, exchange rates can be volatile and deviate from fundamental “fair value” for significant periods of time. Emerging Markets have certainly been negatively impacted by a series of negative shocks in recent years also, which have contributed to their relative underperformance. We continue to believe however that the undervaluation of EM exchange rates, combined with a credible policy framework in most instances, will act as “pull factors” for global capital. Furthermore, the US dollar has been relatively strong for some time, even considering the declines seen in the second half of 2020. This overvaluation may ultimately lead to the beginning of a significant depreciation. Such an eventuality has historically been a good backdrop for Emerging Market assets, both local and hard currency denominated.
What is the impact of Covid-19 on Emerging Market currencies and bond markets?
Vulnerability to crises was previously a feature of many Emerging Market economies, but today that vulnerability is lower, at least for the major issuers of local currency emerging market government bonds. According to Colchester’s analysis, the market turmoil and economic contraction associated with the COVID-19 pandemic was met with a strong policy response from central banks in many major Emerging Markets.
Do you see a dollar weakening trend as being more beneficial to hard currency due to reduced interest payments or local through currency effect?
As shown in the chart below, historically there has been a relationship between movements in the US dollar and the relative performance of hard versus local currency EM government debt. Typically, although not always the case, we see local currency outperforming in an environment of US dollar weakness and vice versa.
Source: JP Morgan and Colchester Global Investors. Data is calendar year returns from Dec 2003 to Dec 2020. Hard Currency is the JP Morgan EMBI Global Diversified Index (EMBI GD index), and Local Currency is the JP Morgan GBI-EM Global Diversified Index in USD Unhedged terms.
The outperformance of the Local asset class from a weaker USD tends to be driven by an appreciation of EM currencies. When we look at USD hedged returns of EM Local bonds versus Hard Currency bonds, we see a general trend of Hard Currency outperforming EM Local bonds.
With regards to a weaker USD improving debt servicing for a sovereign’s Hard Currency debt, certainly an appreciating local currency will tend to make the conversion of domestic revenues into USD less costly, and thus somewhat ‘cheaper’. This is one reason why when assessing Hard Currency debt we incorporate the valuation of the country’s Real Exchange Rate. Colchester looks at several factors when assessing Hard Currency debt serviceability which focus on a country’s external liquidity, including the ratio of a country’s foreign currency uses relative to its foreign currency resources, and the Terms of Trade.
This article should not be relied on as investment advice. Colchester Global Investors Limited is regulated by the UK Financial Conduct Authority, and only deals with professional clients. https://www.colchesterglobal.com for more information and disclaimers.