As a topic often discussed by investors and allocators, I wanted to share my views on positioning hard currency versus local currency, as well as some additional thoughts on various opportunities within the Emerging Markets (EM) universe.
The argument around hard versus local currency can be considered something of an apples to oranges comparison. Local currency, generally speaking, can be much more volatile than its hard currency counterparts and thus offers a pretty different risk profile to investors. This was seen quite clearly in 2020 when the hard currency Bloomberg Barclays EM USD Aggregate 1-5 Year Total Return Index (BEM5TRUU) returned 4.53% with a volatility of 24.74% while the local currency index, as represented by the JPMorgan GBI-EM Global Diversified Index (JGENVUUG), returned 2.69% with a volatility of 79.96%.1
Given these differences in characteristics, a few key points to highlight would be as follows:
1. Not all EM currencies behave the same way and neither do all EM hard currency bonds. Simply asking the question “hard or local” is not enough. Instead, we should aim to look individually at the specific hard currency opportunities and local currency opportunities for 2021. Areas to think about would be:
a) Hard currency – long duration versus short duration? Investment grade versus high yield?
b) Local currency – which countries? Commodity exporters or manufacturers? Long duration versus short duration?
There are 75+ emerging market countries out there and the correlation between these countries can differ significantly. Following an opportunistic philosophy that aims to capture currency (FX) and local bond trades should allow investors to take advantage of interesting risk-reward profiles.
2. Additionally, our team considers hard currency short-duration credit to be the most attractive risk-reward opportunity in the EM universe, and therefore aim to anchor our strategy to this. Not to say this is the only opportunity, as demonstrated in 2020, where we were able to find opportunities across EM hard currency bonds; EM local bonds and interest rates; in EM equity indices and single names; in long and short positions. We are of the opinion that core positions should provide lower risk returns, while higher risk opportunities should only be taken where we believe there’s a reasonable risk-reward payoff.
3. We view EM local bonds to be an opportunistic alpha generator to be layered on a core EM credit portfolio. Much of our view is dependent on the outlook for the US dollar which has already weakened significantly (benefitting EM FX). While this dollar “bear cycle” could persist for several quarters to come, it does not come without volatility and we continue to view EM local bonds as primarily an FX trade.
We believe that EM local currency as a stand-alone asset class is not an attractive investment in the current market environment.
Returns from local bond duration in EM have largely been “tapped out” following unprecedented monetary policy easing in the wake of COVID-19. We see very limited room for further rate cuts across EM. With only two or three exceptions, central bank policy rates are now at historical low. This can be seen by the graph below where the average EM policy rate of the top weighted countries in the JP Morgan GBI-EM Index has declined significantly over the last couple of years.
Average EM Policy Rate* (%)
Source: Aperture Investors, LLC and Macrobond. As of January 25 2021.
Policy Rates by Emerging Market Country (%)
In addition to the graph above, we can see the point further emphasized here where across emerging market countries current policy rates for most countries are near the lows of their 10-year range.
Source: Aperture Investors, LLC and Macrobond. As of January 25 2021.
Going forward, our view is that local EM bond markets will mostly be a “carry” play (with very low starting yields) and returns will be heavily dominated by FX spot volatility. At present, referencing the graph below which shows FX carry relative to volatility, we would consider these to be unattractive in most FX markets and view EM hard currency fixed income as a better long-term risk-reward investment with historically strong Sharpe ratios.
EM FX Carry-to-Volatility
Source: Aperture Investors, LLC. As December 31, 2020
1 Source: Bloomberg Finance L.P, as of December 31 2020. Volatility calculated as the standard deviation on daily returns.
Originally Posted on February 22, 2021 – Positioning Emerging Markets Local Currency vs. Hard Currency in 2021
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