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Economic fundamentals boost em debt

December 2020

EM local bonds shine in a low-yield world

With developed market yields stuck at zero, EM local bonds look increasingly attractive, especially given these economies' strong fundamentals.

The stars are aligning for emerging market local debt. The asset class may have been in the doldrums since the global financial crisis, but it is now poised to outperform thanks to a raft of positive factors – from emerging markets’ solid economic fundamentals and undervalued currencies to the prospect of zero interest rate policies in developed economies for years to come. As a result, the asset class makes a strong case for inclusion in yield-starved portfolios. 

Compelling fundamentals

Those positive economic fundamentals underpin the case for a dependable flow of returns from emerging market assets, allowing them to replace yield that other investments no longer provide.  

The Covid pandemic has been destructive for economies around the world. But emerging market countries are rebounding sharply. Apart from services industries, economic activity has recovered to December 2019 levels for these countries overall. 

To be sure, the strength so far has in significant part been driven by a rampant Chinese economy, where the likes of car sales, construction, industrial production and exports are well above where they were a year ago, and retail sales only just below. But the wider recovery looks to become increasingly self-sustaining. That momentum will only build as Covid vaccines become widely available over the coming months.

Indeed, emerging market economies are outperforming their developed market counterparts. EM industrial production is running at above fourth quarter 2019 levels, while in developed economies it continues to lag by some 6 percentage points. The fact that EM economies are much more heavily geared to industry and less to services – developed economies are some 70 per cent services against 54 per cent in emerging economies – is a key factor for the differential in economic performance.

Fig. 1 - Real yields
10-year government bond yields deflated by core CPI
10-year government bond yields deflated by core CPI

Source: Pictet Asset Management, CEIC, Refinitiv, Bloomberg. Data as at 31.10.2020.

Meanwhile, the outlook for global trade is increasingly less gloomy. That’s critical for EM economies, given their relatively heavy reliance on exports compared to their developed counterparts. Global trade was already suffering under President Donald Trump’s anti-trade policies, particularly against China, when the Covid shock hit. Recovery, when it came, was just as sharp. That return to health is set to continue under a Joe Biden presidency. True, trade tensions between the US and China are unlikely to disappear completely – geopolitics is likely to ensure the two behemoths remain wary of each other’s intentions. But relations between the US and its other trade partners are bound to be considerably more diplomatic and less fraught.

Increasingly robust global demand – not least from China – will continue to support commodity prices. And given the relative weight of commodity exports in their economies, this should offer further support to emerging market countries.

Attractive valuation

As an asset class, emerging market local currency debt has been a source of frustration for many investors over much of the last decade. Investment returns failed to keep up with ever improving fundamentals. This was, however, largely down to challenging external factors, such as a strongly appreciating dollar. A raft of negative headlines specific to a handful of leading EM countries only made investors more wary.

Now, though, improvements to the global macroeconomic and policy outlook come against a backdrop of deeply attractive valuations and historically light investor positioning in EM local currency debt. As a result, yield-starved investors are increasingly being drawn to the asset class. The economic growth outlook is likely to translate into relative strength for EM currencies. That upward pressure is supported by interest rate differentials. Nearly all major developed countries' 10-year government bonds are posting negative or zero real yields. With 76 per cent of developed market (DM) sovereign debt now trading at negative real yields, DM investors are being forced to search for alternatives.

Fig. 2 - Going cheap
Emerging market currencies valuation relative to USD
EM currencies valuation relative to USD

* Unweighted 31 EM exchange rates vs USD
** Based on relative prices, relative productivities and net foreign assets
Source: Pictet Asset Management, CEIC, Revfinitiv. Data from 01.01.1980 to 01.12.2020.

That’s likely to persist given both the US Federal Reserve and the European Central Bank have shown commitment to keeping interest rates at or near zero and to putting downward pressure on yields along the curve.

By contrast, equivalent sovereign debt in most EM markets offers solidly positive real yields, ranging from 2 per cent to just under 6 per cent (see Fig. 1). Pictet Asset Management economists estimate that EM currencies are some 25 per cent undervalued, which should give them further support (see Fig. 2).

Making EM sovereign bonds more attractive still, debt levels in emerging market economies are considerably smaller than in developed countries – our economists forecast a debt to GDP ratio of 66 per cent for EM economies versus 127 per cent for DM in 2021.

Go with the flow

Emerging markets now represent some 50 per cent of global GDP. A proportion that will only increase as these countries catch up with the developed world in per capita output. Yet emerging market assets represent a disproportionately small fraction of investors’ portfolios – a proportion that’s declined over recent years. For instance, foreign ownership of many emerging market local currency bonds is at or near 10 year lows (see Fig 3).

But flows have been returning to emerging market assets. EM hard currency bonds have been boosted by  demand from foreign investors hungry for yield. As emerging economies’ strong fundamentals  become increasingly obvious, more investors will start to notice the benefits of EM local currency bonds as well, at which point a lack of positioning could spark a sudden and dramatic surge in prices. The speed of a move is only likely to be boosted by the fact EM local currency bonds are increasingly easily accessible. Demand, in turn, will be supported by a growing local institutional investor base. Indeed, EM inflows are running at their strongest rate for nearly a decade and, in the fourth quarter of 2020, are on track to see the strongest quarterly inflows since the first three months of 2012.

What’s more, this stage of the global economic cycle – when economies worldwide are recovering from a downturn, with growth momentum on the upswing – is the best phase for risk assets to outperform. This should particularly benefit emerging market currencies and bonds.

Fig. 3 - Underowned
Foreign ownership of emerging market debt, % of outstanding 
Foreign ownership of EM bonds

Source: Haver Analytics, Morgan Stanley Research. Data from 31.01.2012 to 31.10.2020.

In a world where yields on assets have almost universally been crushed by aggressive monetary policy, emerging economies still offer positive real yields – particularly bonds priced in local currencies. At the same time, strong economic fundamentals will tend to support these currencies against the dollar, offering foreign investors yet more upside. For more wary investors, a blend of EM hard and local currency bonds offers attractive returns with less currency impact. In other words, EM local bonds are a beacon for yield-starved investors.