Bond Bulletin

Time for a tactical look at emerging market local currency debt

GFICC Investors

Published: 19-09-2024

The FQT research framework

Functional factors

Include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings, and leverage metrics).

Quantitative valuations

Is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors).

Technical factors

Are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum.

Emerging market local currency debt has historically performed well when the US economy slows, providing exposure to local treasury yields from around 20 emerging countries and currencies. We discuss the characteristics of the current global cycle and how it might differ from previous ones.

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Fundamentals

During global slowdowns in past economic cycles, such as the 2008 financial crisis or the COVID-19 pandemic, developed market (DM) central banks led with aggressive interest rate cuts. Emerging market (EM) central banks followed after taking into account factors such as their local levels of inflation, currency stability and external debt conditions. This time, EM central banks were able to cut rates earlier than their DM counterparts, with the Central Bank of Chile being the first to cut interest rates in July 2023. Inflation cooled across EM countries to comfortable levels much more quickly, partially due to differences in underlying drivers; a large part of EM inflation was driven by energy, food and supply chain shocks vs. stickier services inflation and persistent wage pressure in the developed economies. Most EM central banks have already concluded or paused their easing cycles and shifted their focus towards growth, while seeking to not overstimulate the economy. In contrast, the Federal Reserve (Fed) is delivering its first interest rate cut this week as the US economy softens and concerns are now more centred around downside risks, potentially foreshadowing a dollar softening.

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Quantitative valuations

Risk assets have held up in 2024 as the soft-landing narrative has persisted. However, concerns around the higher likelihood of a recession may prompt investors to revisit their positioning. Historically, emerging market local currency debt has performed well when the US economy is decelerating and the US dollar weakening. This time, the situation could be more pronounced because EM central banks are more likely to hike interest rates than cut them. Investors may have an opportunity to reallocate within the risk asset portion of their portfolios and consider a tactical position in EM local debt. Importantly, annualised long-term volatility of EM local debt is 11.8% vs. 14.5% for the S&P 500 Index. The yield on the EM Local Debt index GBI-EM currently sits at 6.12%, compared to around 3.64% for 10-year US Treasuries (data as of 17 September 24), with the yield differential having increased over the last couple of quarters.

High EM local debt all-in yields are supported by favourable fundamental outlook

High EM local debt all-in yields are supported by favourable fundamental outlook

Source: Bloomberg, FactSet, J.P. Morgan Credit Research, J.P. Morgan Asset Management. Indices used are Bloomberg except for EMD (USD): J.P. Morgan EMIGLOBAL Diversified Index. Data as of 17 September 2024.

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Technicals

In the EM local debt space, around USD 50 billion is held in mutual funds and another USD 11 billion in ETFs. In the last couple of years, the whole EM debt sector has seen sizeable outflows. EM local debt funds have been hit relatively hard, with outflows of around USD 4.4 billion year-to-date, reducing total assets under management by around 7.2%. This period of outflows may be about to change. Month-to-date flows have put the net negative flow trend on pause as investors appear to be factoring in softer recent US economic data and the Fed’s rate cut. As this trend continues the attractiveness of the sector increases. We expect demand to improve as investors attempt to play a compound return from a potential dollar softening paired with higher local currency sovereign yields.

What does this mean for fixed income investors?

Fixed income investors might find emerging market local currency debt appealing in the current economic climate. As the US economy slows and the dollar potentially weakens, this asset class has historically shown strong performance. With emerging market central banks having already paused or concluded their easing cycles, the focus on growth could offer attractive yields and reduced volatility. Investors may find it an opportune time to consider a tactical allocation to EM local debt.

About the Bond Bulletin

Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.

Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.



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GFICC Investors

Published: 19-09-2024

The FQT research framework

Functional factors

Include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings, and leverage metrics).

Quantitative valuations

Is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors).

Technical factors

Are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum.