From 2013's Taper Tantrum to the pandemic and the war in Ukraine – there's been much with which to contend. Throughout these ups and downs, we've consistently generated alpha. Driving this has been our long-term, bottom-up fundamental research-based investment process, which helped us appropriately calibrate opportunities and risks.
As we look to the next 10 years, let's examine the factors that have shaped the performance of this asset class and consider the prospects ahead.
A quick recap
A common misconception is that emerging market (EM) debt, or local currency bonds, is a volatile asset class, with returns that don't compensate for this turbulence. The reality, however, is different. Since the EM Local Currency Index started 20 years ago (Chart 1), the asset class (grey dot) has sat alongside EM hard currency sovereign bonds from a risk/return viewpoint (with risk measured by standard deviation).
Chart 1. Selected bond asset class risk/return (2003–2023)
Source: Bloomberg, JP Morgan, abrdn, 30 June 2023, returns in EUR since January 2003.
The importance of inflation
When the primary EM local currency bond index (JPMorgan GBI-EM Global Diversified) was launched in 2003, its yield was just over 6%. Since then, the annualized total return for the index has been just over 6%. However, the total return to US dollar-based investors has been slightly above 5%. For Euro-based investors, it's a whisker below 5%.1
Like many other bonds, it's clear the starting yield level approximates eventual long-run total returns. What causes this? Put simply – inflation. Over extended periods, purchasing power parity holds. By this principle, EM inflation has averaged about two percentage points higher than developed market inflation. This corresponds to the long-run drag from currency returns for local currency EM bonds. The more a country's inflation is above US inflation, the more its currency depreciates versus the US dollar.
When investing in EM debt, we seek to understand the key drivers of inflation and to accurately forecast inflation levels. There are two main ways in which inflation can hurt investors in EM debt. First, when inflation rises, bond yields also tend to rise (prices fall). And second, persistently high inflation compared to trading partners usually causes currency depreciation. It's worth noting that rising inflation between 2021 and early 2023 hurt EM bond markets. However, the fallout was less pronounced on EM currencies. This partly reflected the temporary nature of inflation rises and, more importantly, that US and European inflation rose to similar levels.
The inflation differential (a determinant of long-term currency returns) didn't change much. Given this, one of our key objectives is to allocate to countries that offer high yields relative to inflation – i.e., high real yields. Accordingly, part of our research is to anticipate inflation dynamics which, if they differ from market expectations, can enhance returns relative to the index.
Looking ahead
Following the substantial repricing in 2022, we're optimistic about EM debt. Headline inflation rates across EM have declined in lockstep with commodity prices (notably food and energy). For the first time in two years, we're seeing inflation surprise to the downside in some places. This opens the door for potential rate cuts in Q4. Indeed, Chile and Brazil have already reduced rates. With the beginning of EM cutting cycles approaching, we believe it's better to be early than late in taking long-duration positions. Of course, selectivity will be key given the significant inflation and policy cycle variance among EM countries.
Despite the relative resilience of returns in the last three volatile years, EM debt remains attractive and above their long-term average level. Furthermore, EM central banks are not targeting low interest rates in this cycle. This should support real yields, with scope for capital gains as central banks reduce rates.
The value of investments and the income from them can go down as well as up in investors may get back less than the amount invested. Past performance is not a guide for future results.
1 abrdn, October 2023.
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