By Peter Eerdmans , Co-Head of Emerging Market Fixed Income
It’s been a fantastic run for local currency emerging market debt (EMD) this year – up around 15% (in US dollars)1 and on track for its best return since 2009. Despite the strong rally, we believe that at a time of stretched valuations across other capital markets, local currency EMD is one of the few global asset classes offering genuine value. Both elements of local currency bond returns – yield and FX – appear to have room to appreciate further from current levels, particularly in high yielding markets.
If we turn to yields first, the GBI-EM weighted index yield is hovering around 6% at present. This remains relatively high compared to history, but on a real (inflation adjusted) basis valuations look even more attractive. The below table highlights the scale of disinflation across some of our key markets.
Across many EMs inflation is now at record lows
|Current consumer price index (CPI)2||10 year CPI average|
Source: Bloomberg, 30 September 2017
Pleasingly, monetary authorities have shown unprecedented discipline when reducing interest rates – a function of the increasing independence of EM central banks and their adoption of explicit inflation-targeting regimes (in countries as diverse as Argentina and Ukraine). While some central banks began easing monetary policy to support their economies – particularly in recession-hit countries like Russia and Brazil – they have done so in a largely credible fashion, ensuring inflation expectations remain anchored.
Consequently, interest rate reductions have generally been quite modest which has helped keep real interest rates and local bond yields high versus history. This relationship appears particularly noticeable when we compare the real yield between high and low yielding EM bond markets, as can be seen in Chart 1. In the high yield space, real yields remain close to their highs. With structurally lower inflation being sustained by credible central bank policy, nominal yields should continue falling outside of any external shock. By contrast, low yielding bond valuations look closer to fair value, although they don’t look exorbitantly expensive relative to history.
Chart 1: GBI-EM real bond yields across high and low yielding markets
Source: Haver, Bloomberg and IAM September 2017
Chart 2: EM real yield differential over developed markets remains elevated, and above its historic average
Source: Source: Haver, Bloomberg and IAM September 2017
This real yield buffer should continue to support foreign inflows, especially considering the attractiveness of EM currency valuations. On a nominal effective exchange rate basis 3, EMFX performance this year has been lacklustre given the strength of the euro. Similarly, using the real effective exchange rate (REER) method4, EMFX also looks inexpensive compared to history, particularly high yielding EMFX5. Even after accounting for the changed macro environment, we believe EM REERs for a number of high yield currencies remain 5-10% below fair value.
Chart 3: ELMI weighted REER high yield vs low yielding currencies
Source: Haver, Bloomberg, JPMorgan and IAM September 2017
The robust growth outlook across emerging markets should support further REER appreciation over the next few months, as we are still at a relatively early stage in this cyclical pick-up. As well as positive bond flows, equity flows should also be supportive given positioning remains light (indeed there has been net selling in recent months) and the fundamentals are improving, with net income margins rising, and as Chart 4 highlights, forward price-to-earnings (P/E) ratios6 still attractive relative to history and developed markets.
Chart 4: Developed vs emerging market equity valuations using P/E ratios
Source: Haver, Bloomberg and IAM September 2017
Thus we see fundamentals, valuations and positioning all still lining up positively to support local currency EMD over the medium term. With several emerging market economies also set to benefit from an increased stock of capital, technological progress and pro-market structural reforms this allocation argument is only strengthened.
1 As at 30 September 2017
2 Year-on-year change in the index
3 The weighted average rate at which one country’s currency exchanges for a basket of other currencies, not adjusted for inflation
4 The weighted average of a country’s currency relative to an index or basket of other major currencies, adjusted for inflation
5 FX valuations need to be framed within the context of the end of the commodities super cycle, which drove the structural break in EM growth to a more sustainable, but lower rate, as well as driving the deterioration in in commodity terms of trade
6 The forward price-to-earnings ratio is a company’s current stock price divided by its estimated earnings per share
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Issued by Investec Asset Management, issued December 2017.