Emerging markets debt in Goldilocks situation

EMERGING markets debt (EMD) has staged a strong recovery this year with total inflow already at US$25 billion, the highest since 2012. The recovery is particularly impressive in EM local currency debt, with a total return of 14.7 per cent in US dollar terms this year as at the end of July, nearly reversing the entire weak performance in 2015.

In this article, we explain why EMD continues to be an attractive diversification in a global bond portfolio in the current environment.

Why EMD?

We see five reasons to support why EMD is an attractive diversification in a global fixed portfolio.

In the IMF's latest Word Economic Outlook, the Fund forecasts global growth to be 3 per cent and 3.4 per cent in its baseline scenario for 2016 and 2017 respectively. The forecast for EM growth stands at 4.1 per cent and 4.6 per cent for 2016 and 2017 respectively.

The yield enhancement is even more pronounced in local currency debt, which is yielding around 6.4 per cent (average rating BBB). As this suppressed yield in developed market countries continues, the demand for EMD is set to grow, most likely in hard currency debt initially and eventually into local currency as the outlook for EM growth improves.

Many EM economies have undergone substantial adjustments, especially via FX depreciation. This is noticeable in the reduction in both the current account deficits and short-term external financing needs. With our expectation that Fed tightening would be extremely gradual, commodity prices bottoming at current levels and no hard landing in China, we expect EM growth to recover to 4-6 per cent over the next five years on average.

On the election front, we had a heavy election agenda in 2015 in emerging market nations. Hence, we expect political noise to subside, especially compared with the busy schedule in the developed market world.

EM growth is contributing to 57 per cent of global growth, and yet only 10 per cent of total debt portfolio is allocated to EMD. With the inclusion of RMB into the SDR basket, we believe EM currency's share in global foreign reserves can only increase from here. These all point to higher demand for EMD in the future.

Different types of EMD

There are three main types of EMD funds:

With our view that EM growth will continue to recover, we believe local currency debt offers a high potential in returns over the medium term, especially with a very gradual hiking path from the Fed.

EMFX - what now?

The outlook for EMFX is a key for local currency debt. We think EM countries were right to use EMFX as a shock absorber, and we believe the most violent adjustment in EMFX is behind us for now based on our views that:

We also observe that EMFX is becoming less sensitive to any hawkish Fed surprises. The volatility of EM currencies has also been falling compared with DM peers with the ratio between the two at the lowest since 2013.

In conclusion, we are constructive on EMD and believe this asset class offers good diversification in the current low yield global context. While our strongest conviction right now remains in hard currency debt, we also like local bond duration.

On EMFX, further volatility cannot be ruled out, but the most violent adjustment should be behind us, thus improving the returns potential for local currency debt.

This article was contributed by Amundi Asset Management