Investors in emerging market local currency debt have experienced some big fluctuations over the last few years. If you mistimed your exposure to the asset class at its height in mid-March 2013, then your total return to 28 April 2017 would have been roughly 3.3%... or a mere 0.8% annualised. But a canny sterling investor could have made a 50% return if purchased at the 2015 trough!
After a bumper 2016, returns tailed off in the final quarter, but the first four months of this year have seen a continuation of a revival in local currency bonds. The asset class returned 2.9% over this period, making it one of the top performers in fixed income space (and also one of the top performers if we look across the multi-asset space).
What’s driven the recent positive performance? The commonly quoted ‘yield hunters’ moving away from negative yields in developed markets is a factor, and so is the continued fundamental improvement in emerging markets; emerging market equity is also one of the strongest performers year-to-date.
By breaking down the returns of local currency into three main components - principal (bond price changes), interest and currency - we can see that over the last 5 years to 28 April 2017 there was a negative contribution from the principal component. This was driven by outflows from emerging markets into US denominated assets with the strong dollar both a cause and an effect.
On the other hand, currency and interest were positive contributors to return. The high interest rate offered by local currency debt is in part to reflect higher inflation (relative to developed markets) and also to reflect a higher risk premium in these markets.
But the higher interest rates offered come with a catch. The only way sterling investors can get exposure is to take on emerging market currency risk. The contribution from currency can be a big driver of overall returns and we think currency risk is likely to remain elevated.
The volatility of local currency debt returns has been increasing, and a significant part of this has been driven by currency fluctuations. My colleague Willem in his post reminds us that markets, especially currency markets, don’t tend to move in a straight line – it is fair to expect the market to overreact.
The falls in sterling post-Brexit (see the first white circle above) have led much of the strong returns of the asset class recently. Apart from sterling volatility, much of emerging market currency risk is driven by commodity prices and movements in the US dollar - Donald Trump’s surprise victory is another good example (the second white circle above) of an event that could contribute to currency volatility. So whilst over the last 5 years currency has had a positive impact, currency volatility shouldn’t be understated.
Concerns around ‘Trumpenomics’ and a slowdown in China – the largest buyers of commodities – have not yet materialized, but risks remain. Then there is Brexit, the Italian and German elections - the list goes on. These events can be catalysts for currency volatility. While local currency bonds can offer attractive returns, unhedged local currency bonds could very well turn out to be a currency play (with some yield on the side).
In the past we’ve talked in our blog about being positive on hard currency debt – see John and Emiel’s post. That view remains and we continue to retain a preference for hard currency over local currency debt.
While this is not an overly positive view on local currency, they should be part of a diversified multi-asset portfolio. We shouldn’t forget the benefits of diversification and there are a number of emerging markets countries within local currency universe on which we are positive on. Being more selective within emerging markets will be important as we approach an uncertain future.