The value proposition for emerging markets debt and ETFs, such as the VanEck Vectors Emerging Markets Local Currency Bond ETF (NYSEArca: EMLC), is being refreshed amid low Treasury yields and a weakening dollar.
EMLC seeks to replicate the price and yield performance of the J.P. Morgan GBI-EM Global Core Index. The index is comprised of bonds issued by emerging market governments and denominated in the local currency of the issuer. While the asset class is currently struggling, there’s still a case for emerging markets debt denominated in local currencies.
The case for EMLC gets a lift when considering emerging markets foreign currencies (EMFX) should be boosted by the declining dollar.
EMFX “has depreciated sharply against the U.S. dollar this year, with valuations near historical lows. Although off the lowest levels of March when returns were -15% for the year, EMFX has still detracted approximately 9% from emerging markets local currency bond returns year to date as of July 27, 2020, more than offsetting the positive return driven by local interest rates,” said VanEck head of fixed income ETF portfolio management Fran Rodiloso in a recent note. “We expect that EMFX will be the dominant driver of returns for the remainder of the year, and although further volatility is expected, we believe there is a strategic case for an EMFX recovery even though timing can be nearly impossible to predict.”
Appeal of EMLC
Investors are faced with a lower-for-longer yield environment, but many can still find attractive income-generating opportunities through targeted ETF strategies.
Declining interest rates in the U.S. and expectations that the Federal Reserve will continue lowering rates to prop up the economy could be a catalyst for EMLC. Emerging markets bonds, particularly those denominated in local currencies, are often levered to Fed action because lower U.S. rates can depress the dollar, thereby bolstering emerging markets currencies and assets denominated in those currencies.
As for the dollar’s impact on EMFX, the outlook is compelling for those considering EMLC because there are few reasons the greenback should strengthen over the near-term.
“On the domestic side, there are many reasons why U.S. dollar strength may not continue. Record deficits and economic contraction make the prospect of higher U.S. interest rates highly unlikely for the foreseeable future,” notes Rodiloso. “To the extent that foreign investors lose confidence in the U.S. dollar or seek to diversify their exposure, the U.S. dollar may weaken broadly. However, the U.S. dollar can exhibit strength for extended periods despite these headwinds, because ultimately we believe it is still ‘the’ safe haven asset, and support may be driven by external factors as much as the internal economic position of the U.S.”
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.