Emerging Markets Local Debt: Light at the End of the Tunnel?

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Even if inflation proves to be more persistent, we believe the pressure on local emerging market bonds should diminish over time.

The beginning of 2022 has been marked by a sharp sell-off in risky assets due to expectations of a faster and deeper monetary adjustment in the United States. Losses in fixed income markets were due to both widening spreads and rising Treasury yields. Atypically, local emerging market debt yields have performed remarkably well so far. Is this the start of a turnaround for local EM, or is it too early to tell?

Structural growth issues have been among the root causes of the underperformance of the local emerging markets asset class over the past decade. The combination of a lack of reforms and incompetent policy and/or political uncertainty in major emerging countries has had a negative impact on investment and created greater dependence on foreign trade. Over the past two years, COVID has hit emerging economies harder, with less ammunition than developed countries to stimulate the economy, and with less access to vaccinations. As a result, emerging market currencies have adjusted lower, particularly against the US dollar, not only as a result of capital outflows, but also in some cases as a policy tool to maintain competitive advantage and help current accounts. Looking at global growth, we believe that the withdrawal of stimulus and moderating trend growth should start to favor emerging markets on a relative basis, while recognizing that the effect will only be felt gradually. As such, we attribute much of the recent outperformance to market factors such as defensive positioning and cheap valuations, particularly among some Latin American and African commodity exporters.

Given the high weight of food and energy in the inflation basket typical of emerging markets, as well as lingering supply chain factors, inflation over the past year has been more pronounced and stiffer than expected. As a result, emerging countries have had to adjust their monetary policies earlier and more radically, although inflation remains well above target until 2022. Nevertheless, even if inflation proves to be more persistent, the pressure on local emerging market bonds should diminish over time, as the market has a significant amount of rate hikes already. In our view, real rates on a forward basis now look more attractive in a handful of countries, while real DM yields are still in negative territory and have only started to rise more significantly in recent weeks. In the short term, we see a continued strong rise in US real yields in an environment of high emerging market inflation as the main risk to our more favorable medium-term outlook.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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