Emerging markets (EM) local debt has been among the poorest performing fixed income asset classes over the last three years. As the asset class is composed of sovereign debt issued in local currencies (as opposed to ‘hard currencies’ like dollars and euros), EM local debt markets are impacted by changes in local interest rates as well as by changing currency values. A number of other drivers including developed market interest rates, commodity prices and global economic growth and trade also heavily influence the performance of the asset class. These factors have almost universally acted as headwinds for the asset class since 2013, resulting in the underperformance of EM local debt.

 

We think this may be about to change. As we discuss below, a number of these headwinds look poised to reverse and become tailwinds, or at least stabilize. With valuations (particularly for EM currencies) at or near their most attractive levels in more than 10 years and an index yield over 6.7%, we think that long-term investors should look seriously at the opportunity that is developing in EM local debt.

 

EM currency valuations are back to their cheapest levels in a decade. EM currencies have depreciated materially year to date due to slower global growth expectations, lower commodity prices and decelerating inflation. Corporate scandals and geopolitical tensions have also played a role, impacting some currencies more than others with the Brazilian real taking the hardest hit this year.

 

While these headwinds have not disappeared, currency valuations have cheapened and in some cases, we think long-term value opportunities are appearing. At Babson, we assess value in currencies using a proprietary currency framework that takes into consideration factors including Export Penetration, Real Effective Exchange Rates and Activity, as well as a comprehensive Balance of Payments analysis. The framework enables our portfolio managers to effectively compare both emerging markets and developed markets in order to gauge economic competitiveness and ultimately identify where value exists.

 

Based on this framework, we believe EM currencies as a whole are currently trading close to their cheapest levels since the effective inception of the EM local debt asset class in 2003.

Weakening commodity prices have impacted this measure more than any other factor. But the fact that it has now moved well into “cheap” territory signals that many of these currencies have depreciated beyond levels that fundamentals would suggest are warranted. In fact, we calculate that for current currency values not to be attractive, commodity prices would need to drop an additional 15-20% from these already depressed levels, a scenario we believe may be overly pessimistic.

 

While we think EM currencies as a whole therefore look attractive, it’s important to note that we expect the future performance of EM currencies to potentially vary dramatically. For instance, our currency framework suggests that countries such as Malaysia, South Africa, Colombia and Poland have seen currency adjustments in line with or beyond levels that economic conditions would suggest, while other countries such as Chile, Korea, Romania and Peru appear poised for more downside based on our analysis. In such an environment, selectivity and active management are critical.

 

Funding sources look more than sufficient to cover EM financing needs for next 12 months. Based on Babson’s proprietary Balance of Payments forecasts, projected sources of funds to emerging markets (Foreign Direct Investment, Portfolio flows, and Other flows) will be more than sufficient to cover emerging markets’ financing needs over the next 12 months. A positive net-supply of funds to emerging markets should also provide support for currency valuations.

 

Similar to currencies, while the overall picture looks balanced for emerging markets funding positions, there are notable differences between countries. The adjustment of current account deficits is not equally advanced across all countries and the reduction of inflows into emerging markets, which stems from potential interest rates hikes by the US Federal Reserve (Fed), is unlikely to be homogenous. For instance, sharp falls in commodity prices have resulted in only marginal reductions in the current account deficits of Peru and Colombia, while Malaysia’s current account surplus has shrunk substantially. By the same token, Chile, South Africa and Brazil have seen major contractions in their current account deficits. Most countries in central and eastern Europe are now running current account surpluses or very small deficits.

 

On balance, we believe the overall funding picture for EM countries is supportive but again caution that selectivity on a country-level basis remains critical.

 

Global interest rates likely to remain at low levels. While recent commentary suggests the Fed will likely move to raise rates as soon as December 2015, and UK policymakers appear to be on a similar path, monetary policy on a global basis remains extraordinarily accommodative. The European Central Bank (ECB), Bank of Japan (BoJ) and People’s Bank of China (PBoC) all remain in easing mode and regional economic statistics suggest that tightening is unlikely in the near future.

 

This environment should be supportive for EM debt markets overall. Higher interest rates in emerging markets relative to developed markets create a positive “carry” trade that should continue to encourage investment in EM debt.

 

While Fed rate hikes have historically been associated with reduced portfolio inflows into emerging markets, the reduction in current account deficits and the expansionary monetary policies by the ECB and BoJ should counterbalance the Fed’s effect on EM funding needs.

 

In recent years, emerging markets have used currencies as a mechanism to cope with a worsening global environment characterized by the unwinding of quantitative easing in the US, weak global trade, geopolitical tensions around Russia/Ukraine and the Middle East, slowing emerging markets growth and falling commodity prices.

 

As an asset class, currencies have been the weak link of otherwise decent emerging markets performance. EM investors have been uneasy holding other types of emerging market assets (hard currency bonds, local bonds hedged, and EM equities) in the face of relentless downward currency pressures. Our conviction that the worst may be over for the weakest link among EM asset classes leads us to recommend now as an appropriate time to consider investing in emerging markets across any of its sectors. We believe that EM local debt, which has exhibited particular underperformance for the last three years, is best positioned of all EM asset classes over the next 12 months. This thesis is not based upon the assumption that currency values will appreciate materially from current levels, but rather that they will stabilize, enabling investors to potentially earn compelling returns and to capitalize on the attractive yields available in the asset class.

 

The risks to this thesis include

 • Commodity prices may not have bottomed: In particular we remain concerned about supply/demand dynamics in the oil and copper markets that suggest further downside may be possible

• A larger-than-expected slowdown in global economic activity: We remain cautious on China in particular based on the ongoing slowdown of its economy and the recent policy missteps by the authorities around the domestic stock market and the exchange rate

• Faster than expected interest rate hikes by the Fed

On balance, as we consider the risks (and potential rewards), we believe that now could represent an opportune time for long-term investors to take a closer look at EM local debt.