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30 June 2023
The global appeal of EM local
After being the best performing major global fixed income sector so far this year, we examine the potential opportunities within emerging market (EM) local currency debt for the second half of 2023.
Fundamentals
Emerging market central banks acted early and decisively back in 2021 when few globally saw serious inflationary problems bubbling up. Cumulatively, EM central banks raised policy rates by 28,000 basis points (bps) since January 2021, compared to just 5,000 bps from developed market (DM) central banks. This comes on the back of strict inflation targeting and vast improvements in credibility in EM. Consequently, EM is now firmly in a disinflationary phase. As such, we expect EM average inflation to decline to 5% by the end of the year compared to 9.6% at the start of 2023. On the growth side, even though some slowdown is to be expected given weakening global fundamentals and higher interest rates, EM economies are proving themselves to be more resilient than previous cycles. This is largely due to rebounding Chinese consumption, higher commodity prices insulating government budgets and corporates, and EM corporates being better adjusted to higher volatility in rates than DM peers.
Inflation has peaked and is coming down sharply
Source: J.P. Morgan Asset Management, Bloomberg as of 23 June 2023.
Quantitative valuations
Higher emerging market policy rates have evolved into higher yields for investors investing in the local currency debt of these countries. The JPMorgan Government Bond Index-Emerging Markets currently yields around 6%, which is 2.5 percentage points higher than the 10-year US Treasury. This yield should be considered in the context of around 75% of the index being rated investment grade. Nominal yields are attractive in countries such as South Africa, Brazil and Mexico at 11.8%, 10.9% and 8.6% respectively. When deducting inflation to get to a real yield, this translates to 6.5%, 6.1% and 4.2% for these markets. Although these yields may appear enticing, investors should be aware of the associated currency risks that are inherent to these investments and how they are managed. The highest yielding opportunities may not always represent the most appropriate investment decisions.
Technicals
Structurally speaking, the total size of EM local currency debt has been expanding as these economies have grown and the depth of local markets (larger onshore banks, pension funds, mutual funds etc) has increased. However, foreign investor allocation has not followed, declining from a peak of 25% market ownership in 2017 to 18% on 28 June 2023. This is a positive development for local players who have become much bigger in size, leading to an overall reduction of volatility in this asset class. But it does leave us open to significant upside when global investors return to this space. Tactically speaking, seasonality is supportive in the short term for emerging market local rates. EM local bond rates have fallen – and prices have risen – in the month of July 73% of the time since the 2008 global financial crisis.
What does this mean for fixed income investors?
EM local finds itself in somewhat of a sweet spot for investors. If there isn’t a recession, we expect the high levels of carry to support investor returns. If there is a recession, we expect that central banks cutting rates will support investor returns through capital appreciation. Although this may seem like a win-win, investors should remain vigilant of the potential for inflation to be higher for longer and central banks to resume significant hiking rates.
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.
Fundamental 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
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