Dr Recai Günesdogdu, head of portfolio management at Nomura Asset Management Europe, caution not to give up emerging markets (EM) local currency debt just yet, as the rally is merely delayed, not derailed.
Everything was perfectly aligned for a rally of emerging markets (EM) local currency debt at the start of this year; an ongoing disinflation in the emerging world, attractive interest rates, and, as a result, more rate cuts by EM central banks throughout the year. As if this wasn’t enough, markets were pricing in six to seven rate cuts by the US Federal Reserve, leading to loose financial conditions and a weaker US dollar, both of which would fuel the anticipated rally of EM local currency bonds. Yet, JP Morgan’s flagship GBI-EM Global Diversified Index gave up 3.7% in the first half of 2024, not as much as developed market government bonds (Bloomberg Global Aggregate – Treasuries Index Unhedged USD: -4.9%) one might say, but investors expecting stellar returns were disappointed. We caution not to give up just yet, as the rally is merely delayed, not derailed. The following three reasons should help to understand why the asset class is still of interest:
The fundamental, political and macroeconomic backdrop remains supportive.
One reason for local EM bonds’ poor performance this year was the uncertainty stemming from a string of elections in both the emerging and developed world. The most important EM elections are behind us (e.g. South Africa, Mexico, India) and, in our view, the outcomes have not changed the political landscape substantially. Moreover, macroeconomic fundamentals are still broadly favourable, particularly with external balances and ongoing disinflation. Therefore, interest rates remain attractive and many emerging countries’ central banks are still expected to cut rates. Ultimately, this is what matters most.
Fed rate cuts and fading US dollar strength provide a tailwind
The Fed is expected to start lowering interest rates soon. As of 29 July, market pricing implies two to three rate cuts in the US by the end of this year. Less restrictive US monetary policy should remove a key headwind for EM local currency debt, by curbing further upside potential of the US dollar, which appreciated by 4.7% in the first half of 2024 (Bloomberg Dollar Spot Index). While US interest and exchange rate dynamics are likely to turn more supportive, a second Trump presidency poses risks to this scenario, although the implications are not clear (e.g., Trump argues for laxer fiscal policy and at the same time a softer US dollar).
“Moreover, macroeconomic fundamentals are still broadly favourable, particularly with external balances and ongoing disinflation.”
Attractive valuations present a good entry point
Lower valuations, especially in EM currency markets, offer a potential upside following their recent sell-off. In 2023, the Mexican peso (MXN) and Brazilian real (BRL), for example, gained 15% and 9% against the US dollar respectively, reaching lofty valuations. The slump that caused the MXN to depreciate by 7% and let the BRL plunge by 13% also led to a more neutral investor positioning, based on Bloomberg data. As all EM currencies in the JP Morgan benchmark index depreciated against the US dollar in the first half year, except for the South African rand (+0.9%), currency valuations have become more reasonable across the board, providing investors with an attractive entry point.
While the overall outlook for the asset class is quite positive, active country selection is key in approaching this diverse market segment.
One of the countries we like to put our assets to work in is India. Strong services exports boost India’s current account balance while the benign inflation outlook should allow the Reserve Bank of India to cut rates, although we expect it to wait for the Fed. Indian local currency bonds offer a compelling mix of low volatility in both rates and currency. They also offer attractive yields (as of 26 July, the 10 year government bond yield-to-maturity stands at 6.9%). Having joined the JP Morgan GBI-EM Global Diversified benchmark index in June, the local Indian sovereign bond market is expected to see $20bn worth of inflows through the first quarter of 2025, when India will reach the 10% maximum index weight.
“We caution not to give up just yet, as the rally is merely delayed, not derailed.”
In Latin America, we see value in Brazil’s high-yielding debt market. Brazil’s 10 year government bond currently yields 12%, stripping off inflation leaves a real yield of 8%, one of the highest globally. While we have long acknowledged the uncertainty around fiscal policy and trimmed our overweight position, President Lula still appears committed to fiscal responsibility, and Brazil’s economic fundamentals remain favourable (e.g., robust growth and ample currency reserves). Finally, Banco Central do Brasil commenced its rate cutting cycle a year ago – we expect more reductions to come in the medium term, supporting bond prices.
One major market we are staying away from is China. The real estate sector seems unable to escape its slump, growth dynamics are still rather sluggish and debt levels pose a threat to financial stability. President Xi’s tighter grip on power does not change our view for the better – we remain underweight in Chinese local government bonds.
*Dr Recai Günesdogdu has been Board Member and Head of Portfolio Management at Nomura Asset Management Europe KVG mbH since May 2024.
