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EM Local Currency Bonds: The dog days are over

By Alexis de Mones, Gustavo Medeiros

Alexis de Mones (Portfolio Manager, Local Currency), and Gustavo Medeiros (Ashmore’s Global Head of Research). During this live webinar they discussed the opportunities present in Local Currency Bonds.

The discussion covered their views on the topics below, and more:

  • EM vs DM monetary policy divergence
  • EM local bonds remains unloved and unowned.
  • EM LC underperformed in the 10 years since Taper Tantrum.
  • The tantrum this time was in DM. Fear of policy normalization in the rear mirror.
  • US fiscal policy and risks.
  • De-dollarization and end of $ dominance.
  • Always Active: Currencies, Bonds, and Themes
  • The impact of a weaker USD on other EM asset classes

Watch video

Transcript is available below.


Ted Smith: Good day, my name is Ted Smith, and I'm a member of Ashmore’s Institutional Business Development team based in New York. Welcome and thank you for joining Ashmore's webinar titled: ‘EM Local Currency Bonds: The Dog Days Are Over’. 

Our two presenters today are Gustavo Medeiros, who's our Head of Research and really the point person for macro discussions within our Investment Committee at Ashmore, and Alexis De Mones, who is a Portfolio Manager for our EM Debt team, and he's also based in London. Alexis and Gustavo, thank you for joining us today.

To all those attending, thank you as well for joining. If you do have additional questions, and you would like any follow-up information about what we're discussing today, please contact a member of the Ashmore Business Development team, and we'll be sending out a follow-up email with the webinar information and a replay at your convenience. You can use that if you'd like. Feel free to share that with your colleagues as well if you think they'll find it valuable. 

So, back to our topic for today, it's Emerging Market (EM) local currency bonds, and I think most folks would be surprised to hear that it is one of the leading asset classes on the planet year-to-date in terms of bonds. Gustavo and Alexis will share with you a little bit more of the numbers that are a surprise of most of our clients and most of the folks we talk to in the field. It's really an untold story and one that is evolving as we speak. We thought it would be interesting to have a webinar and talk to Alexis and Gustavo to talk about what's happening and what we see going forward. So I'm going to hand it over to you, Gustavo.


Gustavo Medeiros: Thanks Ted, thanks everybody for dialling in, and thanks Alexis, for joining us. So, the reason for the title ‘The Dog Days Are Over’ is basically, as it says on the tin, the asset class had been underperforming tremendously in the decade up to 2021 in particular. And what not a lot of people notice is that in 2022 the asset class started to outperform global bonds. EM local currency debt was down 11% last year, but if you compare that with the World Government Bond Index (WGBI), which was down 18%, you can see that obviously there was quite a tremendous outperformance on the full year. 

Year-to-date so far, the asset class is up about 7.5%, and that again compares with US Treasuries that are close to flat, and the WGBI, which is up only 1%. So this is the second year of EM local currency bond outperformance. 

There are three main reasons behind this outperformance. The first one is fundamentals. EM central banks implemented much less aggressive fiscal expansion policies during the COVID crisis and as a result they accumulated much lower macroeconomic imbalances. In particular, the combination of fiscal policy and monetary policy is what really matters here, as most EM central banks were early in tightening monetary policy and increasing interest rates as early as Q1 2021. These higher levels of interest rates have been supporting total returns. 

And finally, EM foreign exchange (FX) reached extremely attractive levels a few years back, but now we have quite a lot of triggers that would potentially lead EM currencies to outperform, which we will discuss a little bit during the webinar. 


But first I would like to ask Alexis to expand one the reasons for EM local currency performance, particularly on the rate side.


Alexis De Mones: Thank you, Gus. We'll cover the rates aspect and the importance of income or the interest rate contribution to return. I'll use the one-year numbers so that it is easier to look at it on a 12-month basis. 

I would compare the local currency EM debt index, which has returned 11%, with the 12-month return for intermediate US Treasury securities, which have effectively gone -0.5% over the same 12-month period. So that's 11.5% of difference in returns. 

Out of that, a lot comes from the fact that we started at a level of interest rates, monetary policy rates, so front end, but also the whole of the curve, that was higher. So, you're investing in securities that have a lot more income. The income in these securities over the last year have averaged about 6.5%, while the income from US Treasuries started from a much lower level, with some having very low coupon. I'd say this 11.5% excess return of WGBI over the Treasury Intermediate Index, half of that comes from difference in income.

Then you have better performance from the curve, so there's the price returns. The interest rates have come down a little bit, so you get capital gain. That's another quarter of your difference in returns. And you can do the math yourself, the FX contribution is the residual, and it's only about 2.5%. So, you don't need to have spectacular performance from pure FX returns to get a good level of excess return in the EM local currency bond market. 

Now, we remain constructive on the outlook for rates, as some of the drivers that have led to this excess return over the last year are expected to continue. I look at the current difference in income between, say, our asset class and the US Treasury Intermediate Index, where at the moment, average income is 7% in EM local bonds, and average income in intermediate Treasury securities is 4.5%. You already have this 2.5% of premium. 

The second thing in terms of capital gain is that price returns within interest rates will continue actually falling in EM. They have fallen more than in the US, and there are reasons to believe they'll continue falling because EM central banks are in a rate-cutting cycle already. That's very important. 

We also hope that global core-bond yields will also fall, and Developed Market (DM) central banks, starting with the US Federal Reserve (Fed), will also help in that interest rate environment. 

So Gus, from your perspective, why don't you walk us through your prognosis for core-bond yields, and how that can effectively help also EM local bond markets perform?


Gustavo Medeiros: Sure, it's interesting because year-to-date on core-bond yields, or if you look at 10-year US Treasuries, they very recently retested the highest levels that we traded pretty much since 2007. That was on the back of quite a lot of issuance, and a very much-wider-than-expected fiscal deficit in the US that is putting pressure particularly on the back end of the curve. 

Now if you look at the fundamentals, there's been quite a lot of disinflation on the economy, which is expected by, backed by lower manufacturing prices. Global manufacturing purchasing managers’ indices (PMIs) have been in contractionary territory for almost a year now, on tighter credit conditions. The real estate market is softening as well. So, there are quite a lot of fundamental factors that are suggesting further disinflation so that in the very short term we are trapped by higher commodity prices, which is complicating the case a little bit. 

But in any case, I think EM central banks are in a much better position to react and to respond to any potential adverse situation that comes on the inflationary cycle from a very short-term perspective. 

As we mentioned, the EM fiscal responses were much better during the COVID crisis. So if you look at the 2020 and 2021 DM fiscal expansion compared to EM, DM did more than twice the level of fiscal expansion, and most of that was funded by quantitative easing policies. EM countries did much less fiscal expansion, and obviously very few central banks had to purchase bonds. Where you did have exceptions were in situation where fiscal accounts were much more controlled, as is the case of Indonesia, for example, which is a star performer in terms of its accounts over recent quarters or years. 

Also, the EM monetary policy response was obviously much faster. I mentioned already that central banks started hiking policy rates in 2021, and Brazil started its hiking cycle in Q1 2021. A couple of quarters later, Fed Chair Jay Powell came up with the expression that inflation is "transitory". So, it's pretty obvious which countries were ahead of the curve. 

And then finally, an interesting element is the big divergence year-to-date so far. Treasuries tried to rally and then sold off to the highs again in terms of yield, whereas EM local bonds kept on rallying. There was quite a pretty stark outperformance in EM local bonds versus Treasuries, particularly more recently. In June, for example, EM local bonds rallied or yields on local bonds declined, whereas US Treasuries widened. That again is explained by the fact that EM is already on an easing cycle. 

Now, Alexis, how do you think about these opportunities in terms of local currency portfolios? Can you walk us through a few examples that illustrate the case.


Alexis De Mones: From a rates perspective, I echo what you just said. EM rate levels have been very resilient, to either inflationary surprises in the US and elsewhere, resilient also to confidence shocks and negative risk events like the US regional banking crisis, for instance, which we haven't mentioned. The asset class has marched on regardless of some of the shocks that have impacted other interest rates markets that have probably been a bit more crowded and more heavily traded. A lot more people take positions in Treasuries than take positions in EM local government bond markets. So I think the asset class has benefited from its status as being a little bit under-owned, almost orphaned, I want to say. 

We estimate there is about half as much foreign participation in EM local government bonds today as there was 10 years ago. We're talking about the participation of foreigners in the domestic local bond markets. That's been one source of the resilience, but the second more fundamentally is the fiscal backdrop. We now look at the risk of fiscal stimulus as being really one of the key risks to consider when you're looking to invest in EM local government bonds because, yes, interest rates have come down, helped really by a huge real yield advantage – so yields were much higher than inflation, inflation having fallen. 

But this can only continue for as long as EM governments don't have to borrow exceedingly to finance their fiscal deficits. What we observe has been good discipline in terms of fiscal policy management. So, we love positive real-yield markets, where yields are much higher than inflation. Obviously, that's a given, but more particularly when you have that combined with an orthodox fiscal policy management. Two of the perennial examples of that are Mexico and Brazil, which Gus, you know very well. In both markets, the two-year bond yields are at over 10%, and inflation is below 5%, in the case of Brazil, below 4%, but it's probably troughed. In Mexico there has been huge fiscal restraint almost because of the president's preferences, and also in Brazil following a deal between the executive and the legislative branch. So we like these markets. Fiscal policy has not given us too many grey hairs over the last year in these markets, which has been good.


Gustavo Medeiros: Yes, very good. I think another point to illustrate is how there were a few markets where local investors and foreign investors expected quite a lot of fiscal slippage that didn't take place. All the leftist regimes in Latin America: Chile, Peru, and more recently now Colombia have been struggling to implement their populist answers. And whereas some markets have been benefiting from higher growth as well, as is the case of India and Indonesia, potentially some of the other countries in Asia.


Alexis De Mones: The growth differential really comes into play when we talk about FX. We should talk about FX because obviously in EM FX, there is the dollar leg and the EM FX leg. Gus, can you tell us about the dollar leg and how you see it'll potentially weaken, and maybe cover some opportunities in EM FX?


Gustavo Medeiros: Yes, I think our framework is a very simple one in terms of when you look at the dollar because in terms of valuations, the dollar seems to have peaked last year at a level that is only 10% below the 1985 Plaza Accord, which is when the finance ministers of the US, the UK, Germany, Japan, and other countries gathered in the Plaza Hotel in New York and decided to coordinate intervention against the greenback.


Alexis De Mones: I remember. I was a teenager, and you could not buy any US goods at the time.


Gustavo Medeiros: I definitely don't remember, but I read about that. But more interestingly, 10% above the dollar peak last year, if it was indeed a peak, was 10% above the 2002 peak, which was basically the dotcom bubble that inflated all US assets, including the US dollar, as capital was flowing to the US via the rest of the world. 

So, if you look into these peaks, and if you consider that last year was potentially a peak, you have about 20 years apart from these peaks. And if you look at the troughs, you also have 20 years apart. So it would suggest a 10-year peak and trough. Again, if you look at the reason behind the dollar strength, particularly since 2015-2016, it's really these procyclical fiscal expansions that were initially led by tax cuts by then-President Trump and then secondarily by expenditure increases enacted by Joe Biden, which is really extraordinary. 

We've published a chart in quite a few publications recently that shows the fiscal deficit against the unemployment rate in the United States. Since 1973, so over the last 50 years, there's a very strong correlation between the unemployment rate and the fiscal deficit, but this correlation has completely broken down since Trump came to power, where we have been getting this procyclical fiscal stimulus. That has allowed for an extraordinary environment for profits in US corporations, in attracting a massive amount of inflows from foreign investors, which is obviously reflected on the valuation of stocks, which is a separate story than we're discussing here. 

But the end of US exceptionalism is very likely to also represent the peak of the dollar. More recently, obviously, this massive fiscal deficit that has expanded significantly in 2023 has also been a source of negative sentiment towards US capital markets and the US economy. Investors are already demanding a higher risk premium to buy long-dated US Treasuries. 

Obviously, that should be reflected across capital markets, which it's not at the moment, but we think that's going to change. 

Then finally, when you look at the translation of the fiscal, procyclical fiscal expansions into the capital account, it's a very interesting element because the fiscal deficit translated into current account deficits, as it often does, for economies that are overextending. 

To fund this current account deficit, the US has relied significantly on the capital account, particularly hot money inflows into the equity market. So, we have a situation today that foreign investors hold almost USD 13 trillion of US stocks, whereas foreign investors hold only USD 7.5 trillion of US Treasuries. So the first one is a risk-on trade, the second one is a risk-off trade. Why am I mentioning all that? There is a model that financial analysts discuss which is a bit of a long shot. It's not a forecast, but it's something that may happen in the future that not a lot of people will be prepared for, is if the 'dollar smile' breaks down.

The dollar smile is this model that predicates that if the US economy is outperforming the rest of the world, the US dollar will do well. But if the US economy is in a recession, the US dollar will also do well. The first one is again a risk-on trade depending on capital inflows to the equity space. The second one is predicated on the purchases of US Treasuries. 

But what if the Fed is not willing to cut policy rates aggressively in a slowdown that looks like a soft landing but is slowly becoming a hard landing? Obviously you're not going to have the potential protection, and what you may have in this situation is foreigner investors selling equities to a larger extent than they're buying fixed income, in which case you can actually have the US economy slowing down and potentially going into a recession and the dollar selling off. That would be a breakdown on a key FX model that analysts follow for a while. 

Again, I think this typically happens at market peaks or when the market is already overextended, such as the current situation. It's a little bit of a speculation of what might happen in the future, but I think that the long-term framework of the dollar depending on procyclical fiscal expansions and those being unsustainable, given how large interest payments have become as a percentage of the total deficit, is a very clear one. I think the fact that US capital markets are overextended is clear, in my view.

Now, let's talk about the EM local currency component. Like, one side of the story is the dollar. If the dollar declines much faster, that's going to be a massive tailwind, but how do you stay on the other side of the currency component in terms of EM FX fundamentals?


Alexis De Mones: Yes, so you did mention that the dollar peaked last year, and it peaked despite the number of risk-off events that traditionally would've led to this flight to stability that you mentioned. So the dollar effectively was selling off on both good news and the bad news, which was a very supportive environment for EM local currencies, and EM local currency volatility has come down as a result of that, which has been good. 


I don't think we need to go as far as saying that we're going to have a breakdown of the dollar smile model for EM FX to do well. Very traditionally, mid cycle to late cycle, so once the Fed is done hiking, and the market is preparing for the Fed to start cutting, obviously it removes a key element of support for the dollar, and other currencies do better, which is why the euro is still modestly up versus dollar this year despite a very poor relative economic performance. 

So, it's natural at this stage of the cycle for EM FX to do well. But based on the income and interest rates differential I was alluding to earlier, you don't need EM FX to do super well for the local currency bond asset class to do well. It's just that when EM FX starts running, then obviously the returns are turbocharged. We had returns in the high teens in the good years in EM local currency bond markets, where EM FX was up only 5%, 6%. That was the case, for instance, in 2016-2017, and more frequently back in 2005-2007 particularly. 

Now, there are four reasons why I think EM FX will do well regardless, and taking this backdrop into consideration. The growth differential is helpful. EM economies are actually seeing the growth differential versus developed economies widen. Last year, the growth differential was only 0.3%. This year, sell-side analyst consensus is for a 2.7% growth differential, going even wider next year. That's definitely an element of support. 

Valuations are obviously a very important starting point. EM FX have barely started moving over the one year. EM FX is only at 2.5% versus US dollars, and that's pure nominal FX appreciation. So they still see that 20% shift to fair value based on long-term fair-valuation models based on inflation differentials. The concept of carry is also important. The implied interest rate differential between EM local markets and dollars in FX instruments is 8.2%. That's the carry differential, and It's been a key driver of good performance for EM currencies historically. 

I think we also have to look at risks. Are there risks out there that could actually undermine this story? We've talked about the resilience of the external balance in EM, and because of sound policy management they haven't run large current account deficits. So, this is very different from, say, 2012 or 2013. There's no reason why you would have a shock to the external financing flexibility for EM currencies. They run effectively very, very small current account deficits, some in surplus, but some in deficit, which is easily funded by foreign direct investment (FDI) anyway, so a very healthy basic balance from an external point of view as well. So, I think we have a lot of reasons to be very confident for the year to come.


Gustavo Medeiros: Very good.


Alexis De Mones: Gus, do you want to bring all of this together, wrap up and move to questions from the audience?


Gustavo Medeiros: Sure. We just covered the main points, the main reasons why we think that this very long period of under-performance of EM local currency bonds is over… 


Alexis De Mones: The dog days are over?


Gustavo Medeiros: The dog days are over. EM fundamentals are performing a) better than expected and b) much better than developed economies. 

The growth differential is very interesting. You mentioned this year is is expected to be 2.7%, widening from 0.3%. Next year, consensus expectations is for it to widen again to 3.2%. So the last time we've seen that was in 2009, 2010, when EM growth differentials widened by that amount. So, the fundamentals in EM are turning, and the negative stories that were expected are not taking place. And actually you're still getting quite a lot of structural reforms. 

The second point is, as you pointed out, the EM rates case is backed by fundamentals. Central banks were ahead of the curve, so EM rates do offer quite a lot of carry, which is interesting. Today with attractive valuations, it's a trade that not a lot of investors have, particularly foreign investors. They are very much underweight this asset class, after 10 years of underperformance. And the trend is your friend. Vietnam, China, Chile, and Brazil already cutting policy rates. There are more central banks, at least five other central banks that we monitor, that we think will be easing policy rates within the next, starting in the next six months, potentially. You don't want to fight the central banks when they are in an easing cycle, so EM is ahead of the curve. 

And then finally you have the currency element, which from a dollar perspective, it seems like it peaked from last year, and you have also these very same fundamentals that backs the case for EM bonds backing the case for EM currencies. So I think that's mostly what we wanted to cover. We wrote a piece about that last month. I'm sure Ted would be able to send it across for anybody interested. 

By the way, Jamil, the leading Portfolio Manager for the Local Currency team, sends his apologies. He couldn't join us today, which was our original plan. Ted, any questions from the audience?


Ted Smith:  Sure, we did get several questions. The first is, "What are the key triggers for increased investment in Emerging Markets local currency debt? You all have talked about the past performance and how local currency is positioning, but what is it going to take for the technicals to really shift and create that kind of demand? And how confident do investors have to be that the Fed's rate-cutting cycle is over for that to happen?”


Gustavo Medeiros: In my view, there's a push and a pull element. The pulling element is the EM performance improving and surprising to the upside and EM local bonds outperforming. That starts raising eyebrows. Then finally, the push factor is going to come once dollar-based investors, mostly Americans, but also Middle East and Asian investors that think in dollar terms, start diversifying their exposure away from dollar-based assets into EM assets.

You see that you can invest in 20 countries which offer higher yield and better fundamentals, the currencies are cheap rather than expensive, and they're performing better. When these two factors combine… this is why we're excited about this asset class because the push factor hasn't started in earnest yet. There is some interest, but still very far from what was seen in the 2005 to 2007 or 2009 to 2012 periods, when investors were very keen on the EM local currency bond asset class. I will say 2005 was very good timing, 2012, 2013, not so much, unfortunately.


Alexis De Mones: No, you're right. Flows are starting to come into the asset class. Flows beget better support for currencies, and there's better performance, and better performance begets further flows into the asset class. We're at the early stage of this virtuous cycle, we believe. 

We also believe that people who make money in the asset class are those that don't wait for that to become consensus. It's been quite cyclical in the past, and the reason why it's been volatile is probably because the bigger share of allocation, the bigger flows, have come late in the cycle. So, you know, we think those early investors get rewarded much more.


Ted Smith:  Okay, second question, which is really the 800-pound gorilla. In every meeting that we have with consultants or asset owners, in the US at least, they ask us about China. How does that play into your analysis, and what risks does it pose for the scenarios you're talking about?


Alexis De Mones: So from a portfolio perspective, it's a very good question. You have two ways to think about China, the direct exposure and the indirect exposure. Direct exposure, it's 10% in our benchmark. And so people know that in EM equity benchmarks, it's much bigger. In fixed income, it's quite small at 10%. And it's 10% which, by the way, has performed quite well because China has not grown rapidly, so their inflation actually has been coming down. 

So, interest rates have come down, and from a capital gains point of view, it's really far outperformed many of the other global interest rates markets. It's been actually an area of stability for EM local currency debt markets. 

The second point I would make is that China hasn't actually performed great, as we know, over the last year from a growth perspective. But despite that, EM local government bond markets around the world have done well. There used to be this view that EM and EM FX, particularly a growth-sensitive asset, can only do well when China is pulling the train, and China is growing rapidly. We've seen that even when China is not pulling the train, EM countries can do very well on their own accord. So, that would dispel the fears that people have about the impact of China on EM local currency bonds.


Gustavo Medeiros: I think it's a very good point. Typically, a lot of investors believe China needs to perform well for the likes of Brazil, Chile, Colombia and Latin America to do well. But Latin America has been a star performer, both in 2022 and 2023. By the way, in 2022, many Latin American countries' fixed income markets delivered positive return in dollar terms, which is very rare to see in fixed income markets. That's despite the fact that China growth has been suppressed to the upside. But from the fundamental perspective, I think China is potentially at the turning point – touch wood. 

We're getting more and more incremental policy announcements, but the announcements are more and more and more meaningful, in particular on the real estate situation. Until a month ago, most of the announcements from the People’s Bank of China (PBoC) or from the leadership were directing local governments to implement policies that would support the consolidation of the sector, or would support the conditions of the sector, and make sure that developers are delivering on the houses that they sold. Whereas today or last week, we've had many announcements that have a nationwide impact, including a top-down directive for the banks to lower mortgage rates across all mortgage providers. Mortgages are around 50%-60% of household debt in China, which is about 60% of the GDP. So, if that gets implemented thoroughly, it implies that there's going to be a massive increase in disposable income.


Alexis De Mones: Correct.


Gustavo Medeiros: That's very important for sentiment, because the key reason why Chinese economy hasn't performed as well as people expected following the reopening was precisely sentiment. So, the youth unemployment, the problems with the developers, and the fact that the vast majority of Chinese has real estate as the main asset in their balance sheet, and the real estate situation not getting resolved really was a drag to sentiment. So if they can fix the real estate situation, that could actually lead to a pretty strong boost in sentiment.

And importantly, if that comes together with higher disposable income, that can start becoming a self-fulfilling prophecy and improve GDP growth. We essentially think that the China pessimism we've seen in the second quarter is very close to peak. But China has many problems that are very well known such as its local government debt and the property developer situation. Some people are comparing China today to Japan in the 1990s, which I think is not entirely correct, but I think most of that is already priced in in Chinese capital markets. 

And importantly for this asset class in particular, China is a source of stability, as Alexis mentioned. China didn't do any helicopter money. They didn't experiment with massive fiscal and monetary policy expansion, and that explains why inflation in China and broadly speaking, in Asia, has been much more controlled and why interest rates are low. 

Actually, mortgage rates were already declining in China, which is pretty much 180 degrees away from what is happening everywhere else in the world, where interest rates and mortgage rates are increasing quite significantly. So, China is doing exactly what it says on the tin, providing some tremendous diversification for investors that have Chinese fixed income. And the long-term correlation between Chinese local government bonds and global bonds is one of the lowest.


Alexis De Mones: I've done some work on that.


Gustavo Medeiros: And that remains the case. 


Ted Smith:  We'll wrap it up there. By the way, on the China question, if you're interested, Gustavo Medeiros was interviewed and quoted in the Wall Street Journal today on that topic. So, thank you for your participation, Alexis and Gustavo. Thanks to the audience as well. We had a great turnout today to listen to their comments. We'll send out the replay, and for those of you that ask questions that weren't answered, we'll get back to you individually. Thank you.


Gustavo Medeiros: Thanks, everyone.


Alexis De Mones: Thank you very much.

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