Fundamentals

Emerging market (EM) and developed market countries are experiencing similar macroeconomic conditions: spikes in commodity prices, particularly energy costs; inflation that repeatedly surprises to the upside; aggressive rate hikes from central banks; and now the increased probability of a recession combined with less room for monetary policy easing. In such a risk-sensitive market, investors have held a broadly negative view on EM local currency debt, in line with other risk assets. However, there are some nuances to consider. While the Federal Reserve (2%-2.5% policy rate) and the European Central Bank (0% policy rate) consider hiking rates more than the traditional 25 basis points to be a strong statement, central banks in Brazil (13.25% policy rate), Mexico (7.75% policy rate) and South Africa (5.5% policy rate) have taken more assertive action and thus offer significant value. While inflation will undoubtedly be sticky, we see potential for it to ease if commodity prices moderate or demand softens, which could make EM local currency debt quite attractive.

Quantitative valuations

The risk-off market environment over 2022 has created opportunities in EM local currency markets. In nominal terms, yields are attractive in EM compared to both historical averages and their developed market counterparts. Near all EM local currency issuers (apart from China, Israel and Thailand) have current yields above their ten-year averages. In addition, the average spread of EM local currency debt is at ten-year highs compared to the core rates (Central and Eastern Europe yields compared to German Bunds and all other emerging markets compared to US Treasuries). However, it is also important to view these yields in the context of diverging inflationary environments. Latin American countries and South Africa offer a more attractive mix of nominal yield and inflation expectations than emerging European and low-yield Asian countries. The currency component of EM local currency debt is important to consider in times of turmoil, when US dollar demand tends to be strong; indeed, in recent months dollar strength has led to wide divergences between the market valuations and fair values of EM currencies (EMFX). While the fundamental challenges for the euro and renminbi vs. the US dollar remain a headwind to broad EMFX appreciation, EM local currency debt is cheap and under-owned.

Real yields highlight the geographic divergence within EM local currency yields

Source: J.P. Morgan Asset Management, Bloomberg; data as of 2 August 2022.

Technicals

So far this year, EM local currency funds have experienced outflows, notably over the second quarter, in line with the risk-off tone in the wider market. However, in the last few weeks, EM local currency fund flows have tentatively turned positive and could provide a technical tailwind for the asset class. Investor positioning in EMFX is negative overall, according to our proprietary J.P. Morgan Asset Management positioning surveys. Within EMFX the survey suggests that investors are overweight countries associated with commodities production and underweight Asia.

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.