Opportunities in Local Currency Debt


June 26, 2017


Improving Growth Rates in EM Economies

For the first time in five years, the spread between EM and developed market (DM) growth is widening, which historically has been positive for both EM currencies and flows. This pickup in growth has been driven by important structural reforms over the last few years, including initiatives in India, Indonesia, Argentina and Brazil. Additionally global growth is improving, which is supportive of global trade, and thus, emerging market economies.

EM U.S. Growth Differential & EMFX vs. USD

Source: JP Morgan; Data as of March 31, 2017

Attractive Yield Advantage Relative to Developed Markets

EM local currency debt yields over 6% on average. This is around 100 basis points (bps) higher than the level immediately before the taper tantrum. Nearly 80% of the EM debt index is rated investment grade. In addition, the differential between real EM and DM rates is at the wider end of the dispersion range of the last five years. Real rates in EM are also over 200 (bps) higher than they were before the taper tantrum – and at that time, EM
fundamentals were deteriorating. Today, they’re on the upswing, which gives EM central banks room to cut rates if needed and provides cushion against higher U.S. rates, particularly as the inflation backdrop is improving.

Attractive Carry Profile in EM Relative to DM

Source: Consensus Economics, Goldman Sachs Global Investment Research
EM High Yielders: BRL, COP, INR, IDR, MXN, TRY, RUB, ZAR

Potential for Significant Catch-up in EMFX as Dollar Rally Slows

Historically, carry has represented the bulk of the return for local currency debt, with FX a moderate drag. We see the improved growth dynamics, along with important structural reforms, driving a long-term retracement in EMFX. To put this in context, while EM currencies have appreciated this year, they are still down over 25% on average since the taper tantrum. And, they are down close to 35% from their peak versus the dollar in 2011. Even a moderate catch-up of 10% would serve as a powerful ‘kicker’ on top of high carry.

EM Currencies Have Repriced on Average 34%

Source: Bloomberg; Data as of May 31, 2017

EM Currencies Have Room to Catch up

Source: JP Morgan; Data as of June 15, 2017

EMFX Cheap to Developed Markets Relative to Long-Term History

Not only do EM currencies look cheap relative to their 2011 peak, but also from the perspective of longerterm economic fundamentals. Based upon valuation models that take into account inflation, terms of trade and productivity, EMFX looks cheap versus developed market currencies.

Goldman Sachs Dynamic Equilibrium Exchange Rate


Source: Consensus Economics, Goldman Sachs
Simple Average of 16 EM Currencies Relative to USD (CE3 verses the EUR)

Healthy Technicals, as Inflows Remain Below Peak Levels

Flows into local currency debt have lagged hard currency debt, and the bounceback post the U.S. election suggests that investors remain underweight the asset class but are inclined to add on sell-offs. Inflows into EM local markets further augment growth prospects going forward, as they help reverse some of the financial tightening of the past few years, while improving public finances.

Inflows Into Local Currency Funds Muted

Source: EPFR Global, Country Allocation Database, Morgan Stanley Research

EM Bonds in Global Portfolio

Source: IMF Coordinated Portfolio Investment Survey, Morgan Stanley Research

Benign Monetary Policy Backdrop

Rising U.S. rates are less of a concern in the context of a synchronous global growth environment, given the gradual and well-communicated path of Fed policy. We believe that the European Central Bank remains very deliberate with its exit strategy, and also believe that the Bank of Japan will continue with yield curve targeting.

EM FX Following the Script from 2004 to 2007

Source: SG Cross Asset Research/EM
Blue line: 2004-2007 cycle measured from the start of Fed tightening in May 2004.
Orange line: measured from start of Fed tightening in Dec 2015.

Bottom Line

We believe local currency debt allows investors to capitalize on improving growth, attractive carry, and the potential for a catch-up trade in EMFX. Investors currently remain underweight the asset class, which provides a healthy technical backdrop. In our base case, we see potential for 8-12% per annum returns for local currency debt, driven by both carry and possible EMFX appreciation over the near to medium term.

Certainly there are risks to our view. However, we see them as more idiosyncratic than systemic. We could see periods of support for the U.S. dollar if the U.S. were to implement more growth-supportive fiscal and/ or protectionist measures. However, we believe that these policies are farther down the road than originally anticipated and, if implemented, will not be as aggressive as originally advertised. In addition, we believe that these measures will likely be more supportive of the U.S. dollar versus other developed market currencies, whereas the risks against EMFX are more balanced. Accordingly, we would look to take advantage of any sell-offs to begin to build or add to local currency holdings.

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