Can EM local currency debt markets show renewed resilience?

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While emerging market local currency debt has seen some heavy outflows in 2020 amid wider market fears, history suggests the asset class may rebound strongly, according to Mellon portfolio manager Federico Garcia Zamora.

The twin shocks of the Covid-19 coronavirus crisis and global oil price slump have seen a range of indiscriminate market selloffs in 2020, with emerging market bonds enduring heavy net outflows.

By 27 March this year, outflows from the previous four weeks had erased about US$41bn of net inflows that EM bonds had seen in the previous year, according to Bank of America estimates, with the amount of money exiting EM local currency debt exceeding investments in hard currency¹. Periodic bouts of market volatility have also marked recent months.

Yet for all this, Mellon portfolio manager Federico Garcia Zamora believes the asset class can recover and has endured some even more challenging market shocks in the past. While the Covid-19 crisis is still ongoing, he points to some deeper historic EM local currency debt outflows² from the asset class during the so-called “taper tantrum” of 2013 and the combined oil price collapse and devaluation of the Chinese Yuan in 2015.³

In March, emerging markets initially saw a large sell-off across different parts of the universe in line with many other risk-seeking asset classes. Yet while the current crisis has been serious, so far it is not the worst the market has ever endured. History tells us this is, as it stands, the third worst period of sustained sell offs – from assets within the sector’s JPMorgan GBI-EM global diversified euro unhedged index – the market has seen,” he says.

Garcia Zamora adds that, while recovery in the US and developed markets has been quicker than in emerging markets, he is already seeing some signs of improvement within the EM local currency debt sector, with some currencies strengthening and some potentially attractive new investment opportunities opening up.

He believes the history of selloffs from assets on the key JPMorgan GBI-EM global diversified euro unhedged index during previous financial and economic crises also suggests EM local currency debt assets have a tendency to recover relatively quickly from deep financial shocks⁴. 

If you look at the history of the EM local currency debt asset class there are a number of examples of sharp sell offs and quick market rebounds afterwards. During post shock periods, returns have also tended to be above average and, historically, the deeper the shock, the higher above normal the post shock recovery tends to be,” he says.

So far, we believe EM local currency debt looks set to behave very much in line with prior shocks, with a very sharp sell-off followed by a quick rebound with the asset class recovering strongly. Based on our historical analysis of the sector, we believe the asset class also has further room to continue to recover from recent losses over coming months.

While Garcia Zamora acknowledges concerns about the potential for rising default rates across emerging markets – particularly among those dependent on hard-hit sectors such as tourism, and commodities, or those dependent on remittances – he also believes local currency denominated debt markets offer a degree of flexibility and protection from wider market swings.

Local currency based EM debt markets are not usually as prone to defaults or restructuring as those tied to currencies such as the US dollar because they have debt issued in local currencies and will tend to allow their currencies to depreciate instead. These countries maintain the exchange rate flexibility to react quickly to shocks,” he adds.

Central bank intervention

While action and intervention by developed market central banks such as the US Federal Reserve have been well chronicled throughout the Covid-19 crisis, Garcia Zamora says many emerging market central banks have also been working hard to support their markets.

Emerging central banks have been very active since the Covid-19 shock and some have been quite aggressive in cutting central bank overnight rates, to help protect their markets. Some central banks have also gone a step further into unorthodox policies such as quantitative easing – buying debt issued by their treasuries to help finance wider deficits and to bring stability to local trades,” he adds.

While Garcia Zamora does expect market conditions to improve this year, he points out that emerging markets are not homogenous – with many taking different approaches to the coronavirus pandemic and its wider economic impacts – and that the pace of recovery may vary widely across markets in the months ahead.

Recovery will be country specific and individual markets are tackling Covid-19 in different ways. The countries in the best position to fight this are those that have better macroeconomic frameworks, with exchange rate flexibility, sound and independent central banks and countries that have accumulated savings over the last few years they can utilise right now to help them recover more quickly from the crisis,” he concludes.

¹FT. Investors ditch emerging market bond funds in flight to safety.
²Measured in Euros.
³Mellon analysis as at 02 June, 2020, based on historic JP Morgan GBI-EM Global Diversified EURO Unhedged index data 2006-2018.
⁴Ibid.

MAR001274, GE0153

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