• Even after the Federal Reserve’s (Fed) recent policy surprise, 7 out of 20 emerging market (EM) currencies are trading at lower levels than before the Federal Reserve’s 1st quantitative easing announcement1
• While some countries face external headwinds, many EM countries were able to navigate the market volatility quite well
• With yields above 6.5%, EM local debt currently appears attractively priced on an absolute basis2
• On September 3, 2013, EM local debt was out-yielding U.S. high yield by the most significant margin in history3
• A pick up in Chinese economic momentum also offers a much firmer backdrop for the broader emerging markets
In part II of our series on investing in emerging market fixed income, we shift our focus from EM corporate debt to locally denominated fixed income, substituting currency risk for corporate credit risk in emerging markets. Although the market environment has proven particularly difficult—in fact, in the past five months local currency debt has generated the worst performance of all but one period in history—we believe that the most recent sell-off has created value in currencies as well as interest rates across many emerging markets. In light of recent guidance by the Federal Reserve, we believe that emerging markets could recapture an increasing percentage of investor flows and reverse the recent losses sparked by fears of “tapering”.
How We Got Here
After weaker economic data from key emerging markets disappointed investors, the law of unintended consequences reared its head due to comments by Federal Reserve Chairman Ben Bernanke. The possibility of a decline in the pace of Fed bond buying was cited as the primary catalyst for currency weakness and surging bond yields in emerging markets. Economies that once benefitted from foreign investor flows have underperformed since flows began to reverse.
However, we believe that those moves had overshot. With the recent FOMC meeting serving as a catalyst, we believe that locally denominated fixed income appears as an attractive way to play a less “hawkish” Fed.
As shown in the table above, EM currencies, on average, are only modestly positive on a net basis since the depths of the global financial crisis. All told, the Federal Reserve has expanded its balance sheet by nearly $3 trillion; today, the U.S. dollar is stronger against seven out of twenty emerging market currencies. While we acknowledge that growth has slowed in many emerging markets as of late, we believe that current exchange rates do not accurately reflect the long-term potential of many of these economies. In many instances, EM currencies are now trading at multi-year lows against the U.S. dollar. Additionally, with only a single exception (the Chinese yuan), EM currencies continue to trade well off their high water marks set in 2006.
Next page: Emerging Market Interest Rates