With mounting pressure on global capital flows to US assets in the face of trade tension and shifting US policy frameworks, local EM debt offers a compelling option for investors.
The case for this asset class is also further boosted by the likelihood of a cyclical downturn in the US dollar.
Already EM local debt has started to benefit from US dollar weakness, and by what Abdallah Guezour, head of EM debt and commodities at Schroders, considers to be the tentative start of a rotation of capital flows away from the US and in favour of the rest of the world.
“After years of global asset allocators being severely under-invested in EM fixed income, EM local currency debt is particularly well positioned to benefit from this rebalancing,” said Guezour (main picture).
Hard to ignore
Investors cannot overlook the strong performance of this asset class amid the global dislocations experienced so far this year.
Reinforcing Guezour’s view, EM debt has shown resilience to current global trade and growth uncertainties – gaining 3.25% during April. This took the year-to-date return of the JP Morgan Government Bond Index-Emerging Markets Global Diversified index to 8.2%.
“This outperformance of EM local currency debt was supported by the long-standing appealing valuations of this sector and the low macro-economic vulnerabilities that several EM countries have been exhibiting,” he added.
Generally lower global growth revisions, especially for the US, have encouraged Schroders to maintain a constructive interest rate duration view, support its bullish EM local rates stance and gain increasing conviction that the US dollar bull cycle is now complete.
In addition, EM capital repatriations have equally gained some attention. Guezour pointed to the example of Taiwan, where the currency has come under intense appreciation pressures because of life insurers trimming their significant US dollar holdings.
Knowing where to look in EM
EM local rates and currencies remain Schroders’ sectorial top picks. “After having shown a remarkable resilience to the recent upward pressures on US Treasury bond yields, we expect the downtrend in EM rates to regain traction,” said Guezour.
Further, EM real yields – those adjusted for inflation – remain close to multi-year highs at a time when growth expectations are deteriorating and EM inflation remains well behaved, especially following the recent drop in oil prices, he explained.
“This, combined with currency strength, should provide several EM central banks with more room to ease monetary policy,” he said.
In contrast, Schroders is more cautious on EM dollar debt, based on a deterioration in growth expectations and the weakness in oil prices, which could maintain pressure in particular on oil-related names.
