Emerging market bonds and currencies have been impacted by heavy domestic factors in recent years, including continued inflationary pressures, political uncertainty and weak economic growth. This year, however, we have seen a clear improvement in the economic fundamentals of emerging countries. Oxford Economics, for example, predicts that the GDP of emerging markets will grow in 2016 by 2% more than developed countries. Russell Investments believes this improvement could initiate a sustained period of better performance for emerging market currencies and sovereign bonds.
We also believe that the asset class likely to benefit most from the emerging economies' turnaround is emerging local currency debt (EMD), i.e. bond issues by emerging market governments in local currencies, such as the real Brazilian, Mexican peso, Russian ruble and Turkish lira.
THREE PARAMETERS FOR EVALUATING EMERGING DEBT IN LOCAL CURRENCY
Of course, some of the news from some of these countries can be worrying, such as the recent coup attempt in Turkey or the outbreak of the Zika virus in Brazil. In order to distinguish and separate the important variables to analyze from the irrelevant ones, our team of strategists constantly analyzes all asset classes according to Russell's model based on Cycle, Value and Sentiment (CVS).
Here's what our approach to emerging local currency debt suggests to us:
1. Value: Our valuation indicators suggest that local currency EMD is attractively priced relative to historical data. This is mainly due to the currencies of these countries. Indeed, we believe that emerging market currencies have fallen enough and are now significantly undervalued. At the end of June 2016, the (inflation-adjusted) exchange rates of major emerging economies such as Mexico and South Africa were well below their 10-year averages. Looking at a 3-5 year time horizon, I believe EM currencies could be stable or strengthen against the US dollar.
2. Cycle: The longer-term structural weakness of these economies certainly persists, but recent economic improvements are very encouraging. In recent months, key indicators in emerging economies have improved, showing better growth dynamics in the second half of 2016. For example, inflation is falling in countries such as Brazil and Russia. The annual inflation rate in Brazil fell from 10,7% in January 2016 to 8,7% in June; In Russia, inflation fell from 15,7% in September 2015 to 7,2% in July 2016. This is certainly positive for currencies and for economic growth, allowing central banks to be able to cut rates. On the flip side, we are of course aware of the risks to emerging markets stemming from a prolonged slowdown in China or a potential rate hike by the US Fed.
3. Feeling: momentum is veering into positive territory for this asset class. One index commonly used to measure the performance of emerging local currency debt is the JP Morgan Emerging Market Government Bond (GBI-EM) Global Diversified Index. The index is currently up 18% year-to-date (as of August 16, 2016) after having dropped significantly over the previous 18 months.
EMERGING LOCAL CURRENCY DEBT CAN THEREFORE DO WELL IN THE COMING YEARS
Despite potential setbacks already highlighted, our strategists believe the long-term picture for emerging market currencies and local currency debt is positive. Compared to developed country bonds, the potential risk/return profile of local currency debt now looks more attractive.
It should be emphasized that, both for an institutional investor and for a retail investor, entering this asset class with the right timing is a significant and difficult variable to evaluate, hence how important the help and guidance of an investment expert is . The main message from our CVS – Cycle, Value, Sentiment approach is that this asset class can be a very suitable choice within a multi-asset portfolio.
