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Having been cautious on the asset class for years, we are becoming more constructive on local emerging debt because of its attractive valuations, the first signs of inflows back into the asset class and a recent improvement in fundamentals.
For many years now, emerging local debt markets have been in the eye of the storm. The impact of the Chinese growth slowdown was felt most in emerging economies which are often highly dependent on commodity prices. A looming string of rate hikes by the Fed also had a depressing effect on these markets, particularly on the exchange rates (versus the US dollar). Years of underperformance resulted in ever more appealing valuation levels for the asset class, but consistent outflows in combination with deteriorating fundamentals kept us from re-entering this market segment. So what has changed?
First of all, in recent months the Fed has turned much more dovish, adjusting its growth forecast downwards and stressing global risks to its growth and inflation outlook. This means further rate increases – if any - will likely take place only very gradually. This will halt the strong US dollar appreciation versus emerging currencies and potentially lure investors back into this market.
Secondly, fears of an imminent Chinese hard landing have receded as the country moved back from focusing on rebalancing the economy to reflating the economy. The approach has helped the local property market to recover dramatically (Shanghai house prices are up 20% this year) and demand for raw material is up on the back of it. Risks of a one-off large renminbi depreciation have abated as outflows continue, but at a more moderate pace. In effect the PBOC is pursuing a policy that has become known as “ease and squeeze”, i.e. easing monetary policy conditions and squeezing the “speculators” who short the RMB.
We also see the first signs of prudent macro-economic policy by central banks (mainly in Latin American countries like Colombia, Peru and Mexico) as they hike interest rates to address the issue of increasing inflation due to rising import prices, despite this being a drag on economic growth. Finally, investor surveys highlight that emerging local debt is underowned after years of underperformance and fund outflows. At the same time, fund flow data show the first signs of net inflow into the asset class. So from a technical perspective this is encouraging.
Although these are positive signs that all support an allocation to the asset class, we do recognize that significant risks remain. First and foremost in China. The PBOC is doing an effective job in managing the short-term challenges of the economic slowdown, but China’s twin problems of high corporate debt and continued excess capacity in the state-owned enterprises have not been resolved and the government’s credit policy further increases the leverage in the economy. Tackling these problems will likely be accompanied by painful structural changes. Another source of risk is the vulnerability of emerging markets to external shocks, particularly to a sudden re-emergence of USD strength if the Fed is forced to hike sooner than what markets are pricing in. Stay tuned.