Insight Investment’s Colm McDonagh assesses whether local currency bonds are a short term trade or a long term alpha generator
It has been a positive year for investors in emerging market local currency assets, especially those with a US dollar base. But is it too late to take advantage of this trend? We believe that the move is more than a transitory rally.
During 2015 and 2016, emerging markets experienced a period of significant capital outflows as markets adjusted to the prospect of higher US interest rates, causing the US dollar to broadly appreciate. This led to a divergence in valuation among emerging market currencies, with many Asian currencies tracking the US dollar upwards while currencies in Latin America and Eastern Europe became undervalued based on their real effective exchange rate.
In 2017, we have seen a reversion to mean, with some previously undervalued currencies moving back towards historical averages. This has caused a virtuous cycle in some markets, with currency appreciation dampening inflation and allowing central banks to reduce interest rates, in turn causing bond prices to rise and driving further currency appreciation.
Although this may seem like a short term fluctuation, there are many reasons to believe this shift in valuations has deeper foundations.
Capital inflows driving currency appreciation
Firstly, there is now less need for foreign capital to finance current account deficits in emerging markets. Before the 2015 and 2016 period of capital outflows, some emerging markets had built up significant external imbalances and were thus left vulnerable to outflows.
The International Monetary Fund (IMF) estimates that the aggregate current account deficit of Brazil, India, Indonesia, South Africa and Turkey (nicknamed the fragile five during the taper tantrum) peaked at $255bn in 2012 but remained well in excess of $200bn even by 2014. By 2016, however, currency devaluations, combined with various policy measures in individual countries, had brought this close to $100bn. With less need to finance current account deficits, capital inflows are instead driving currency appreciation.
Secondly, if the global economy continues to experience relatively broad-based growth, this should continue to be supportive for emerging market assets. Inflation remains at moderate levels, which should grant developed market central banks considerable time to gradually normalise interest rates, lowering the risk of policy error. Global corporate profits grew strongly over the first half of 2017 and this is generally a good forward indicator for future global capex and job creation.
The IMF forecasts that the gap between emerging and developed market growth reached its lowest level in 2015 and that emerging market growth should steadily accelerate in coming years. Although the differential is expected to remain well below the pre-financial crisis highs, it should nonetheless be a driver of future capital flows away from developed markets and towards emerging markets.
Volatility remains a threat
Nevertheless, challenges remain for emerging markets. Heightened political uncertainty has been a problem in recent years and shows little sign of abating. This will almost certainly continue to be a source of future volatility, both for individual markets impacted by specific events and more broadly if policy missteps from the US or Europe affect global sentiment. It is also critical for emerging markets that the policy errors of recent history are not repeated.
As some economies return to stronger, more sustained growth, the potential for a rebuilding of external imbalances rises as well. It is notable that policy makers in many emerging markets have become comfortable with using currency markets as a buffer to insulate their economies from negative shocks. One of the first lines of defence on any political, economic or external shock is to allow currency weakness, with authorities only stepping in to counter falls once they become significant enough for inflation pass-through to become a concern. As long as local bond markets are not disrupted, such a policy can have positive economic benefits.
The dispersion of value across emerging market regions and countries is one which can provide significant potential for alpha generation. If currency valuations continue to revert towards longer term averages, high returns from some markets will like be counterbalanced by losses in others. This would currently favour currency investment in Latin America and Asia over investments in Eastern Europe. Careful consideration is therefore necessary to establish which markets within those regions have the potential for further adjustment and which will be constrained by politics or country-specific issues. However, we remain constructive on local currency bonds and expect demand dynamics to remain strong over the medium term, notwithstanding currency mini – episodes persisting.
Colm McDonagh is head of emerging market fixed income at Insight Investment