EM local currency: Five conviction points

March 28, 2019

2019 has so far been positive for emerging market (EM) assets but returns have not been equally spread.

Local currency assets have lagged behind hard currency so far this year, with the JPMorgan GBI-EM Global Diversified Index for local currency government bonds returning 3.66% versus 6.60% for the JPMorgan EMBI Global Diversified Index for hard currency government bonds (returns to 19 March).

This performance differential has prompted us to re-examine our constructive medium-term bias toward local currency assets, and EM FX in particular.

Is the investment case still positive? We believe so – here are five reasons why.

1. Stronger-than-expected growth impulse from EM

While global PMIs have continued to decline (dark blue line on chart 1), EM PMIs have shown a bounce (grey line), albeit from a low base, while developed market (DM) PMIs have fallen (light blue line).

The slowdown in DM growth (mainly Europe) is one of the main drivers of the global growth slowdown. However, we believe the 22 March European PMI print represents an outlier rather than the norm for the region. Most other recent European data – both hard (industrial production) and soft (Ifo and ZEW surveys) – has been better than expected, providing an early suggestion of a possible stabilisation in global growth.

Interestingly, EM PMIs are above DM PMIs for the first time in the past three years. This fits with GDP forecasts that suggest EM-DM growth differentials are expected to widen in EM’s favour this year.

CHART 1: BUSINESS SURVEYS, MANUFACTURING PMI, SAfive-conviction-points-chart-1.jpg

Source: Markit as at 14 March 2019

If we look at where PMIs are holding up well, chart 2 shows that a number of high yield EM currencies have seen stable or slightly higher PMIs since 12 months ago – namely the Indian rupee, Brazilian real, Russian ruble, Colombian peso, Mexican peso, Egyptian pound and Indonesian rupiah.

CHART 2: 12-MONTH PMI CHANGE

five-conviction-points-chart-2.jpg

Source: Markit as at 14 March 2019

Hence, while we think global growth concern is something that we need to be aware of, we should also be discerning of where the weakness in global growth is coming from. Europe and North Asia are currently weak, but high yield EM is holding up reasonably well.

We are selectively focusing on countries where we believe the growth prospects are still reasonably attractive. We are positioned long Brazilian real, Colombian peso, Chilean peso and Indian rupee while being more circumspect on the offshore Chinese renminbi, South Korean won and New Taiwan dollar.

 

2. Stable China

There is some tentative evidence from Chinese data that a stabilisation is underway. While we do not expect a major reflation (like in 2016), the credit impulse has turned positive and we retain conviction regarding an L-shaped recovery, with the economy bottoming out around these levels. This should push fixed asset investment higher and prove supportive for commodities and broader EM FX.

 

3. Dovish turn by the US Federal Reserve (Fed)

In early 2019, there was a sharp shift in Fed rhetoric, particularly at the January FOMC meeting. The Fed policy stance shifted from ‘normalisation’ to ‘neutral’, putting further hikes into question.

Analyst expectations have quickly shifted from expecting three/four hikes this year to zero/one. This neutral stance was confirmed at the March FOMC meeting, where the baseline scenario was changed to no hikes for this year.

Additionally, an earlier-than-expected end to quantitative tightening was announced. Market pricing in US rates has reflected this – cuts are priced for this year.

While this dovish shift should be supportive of carry trades and high-yield EM FX, we would argue that most EM currencies have not yet priced this in. For example, the JPMorgan EM FX index is close to flat since the January Fed meeting.

Hence, we believe there is significant scope for EM FX appreciation, as one of the main reasons for the lack of EM FX follow through – global growth concern – is now showing signs of green shoots.

 

4. Light positioning

While EM FX positioning has built up since the start of the year, it remains relatively light on a historical basis. For example, fund factsheet data for benchmarked EM local managers suggests that positioning is still below the historical average, and much lower than the peak observed in early 2018.

CHART 3: GBI-EM: PORTFOLIO BETA

five-conviction-points-chart-3.jpg

Source: Morgan Stanley as at March 2019

 

5. Attractive valuations

Our Behavioural Equilibrium Exchange Rate (BEER) valuation framework – which models FX as a function of inflation, terms of trade and productivity – shows EM FX is at its cheapest level since 2005.

CHART 4: AVERAGE EM MISALIGNMENT

blobid1.jpg

Source: BlueBay Asset Management as at 14 March 2019

Acknowledging the volatility in the data, we continue to believe in the theme of global growth stabilisation, noting that it could take one-to-three months for the stabilisation to become clear. If combined with the dovish shift from central banks (particularly the Fed), light positioning and attractive valuations, it argues for a constructive medium-term stance on EM local currency investing.

 

Sign up for insights by email

Subscribe now to receive the latest investment and economic insights from our experts, sent straight to your inbox.

This document may be produced and issued by the following entities: in the European Economic Area (EEA), by BlueBay Funds Management Company S.A. (the ManCo), which is regulated by the Commission de Surveillance du Secteur Financier (CSSF). In Germany and Italy, the ManCo is operating under a branch passport pursuant to the Undertakings for Collective Investment in Transferable Securities Directive (2009/65/EC) and the Alternative Investment Fund Managers Directive (2011/61/EU). In the United Kingdom (UK) by BlueBay Asset Management LLP (BBAM LLP), which is authorised and regulated by the UK Financial Conduct Authority (FCA), registered with the US Securities and Exchange Commission (SEC) and is a member of the National Futures Association (NFA) as authorised by the US Commodity Futures Trading Commission (CFTC). In United States, by BlueBay Asset Management USA LLC which is registered with the SEC and the NFA. In Switzerland, by BlueBay Asset Management AG where the Representative and Paying Agent is BNP Paribas Securities Services, Paris, succursale de Zurich, Selnaustrasse 16, 8002 Zurich, Switzerland. The place of performance is at the registered office of the Representative. The courts of the registered office of the Swiss representative shall have jurisdiction pertaining to claims in connection with the distribution of shares in Switzerland. The Prospectus, the Key Investor Information Documents (KIIDs), where applicable, the Articles of Incorporation and any other applicable documents required, such as the Annual or Semi-Annual Reports, may be obtained free of charge from the Representative in Switzerland. In Japan, by BlueBay Asset Management International Limited which is registered with the Kanto Local Finance Bureau of Ministry of Finance, Japan. In Australia, BlueBay is exempt from the requirement to hold an Australian financial services license under the Corporations Act in respect of financial services as it is regulated by the FCA under the laws of the UK which differ from Australian laws. In Canada, BBAM LLP is not registered under securities laws and is relying on the international dealer exemption under applicable provincial securities legislation, which permits BBAM LLP to carry out certain specified dealer activities for those Canadian residents that qualify as "a Canadian permitted client”, as such term is defined under applicable securities legislation. The BlueBay group entities noted above are collectively referred to as “BlueBay” within this document. The registrations and memberships noted should not be interpreted as an endorsement or approval of BlueBay by the respective licensing or registering authorities. Unless otherwise stated, all data has been sourced by BlueBay. To the best of BlueBay’s knowledge and belief this document is true and accurate at the date hereof. BlueBay makes no express or implied warranties or representations with respect to the information contained in this document and hereby expressly disclaim all warranties of accuracy, completeness or fitness for a particular purpose. Opinions and estimates constitute our judgment and are subject to change without notice. BlueBay does not provide investment or other advice and nothing in this document constitutes any advice, nor should be interpreted as such. This document does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product in any jurisdiction and is for information purposes only. This document is intended only for “professional clients” and “eligible counterparties” (as defined by the Markets in Financial Instruments Directive (“MiFID”) ) or in the US by “accredited investors” (as defined in the Securities Act of 1933) or “qualified purchasers” (as defined in the Investment Company Act of 1940) as applicable and should not be relied upon by any other category of customer. No part of this document may be reproduced, redistributed or passed on, directly or indirectly, to any other person or published, in whole or in part, for any purpose in any manner without the prior written permission of BlueBay. Copyright 2021 © BlueBay, is a wholly-owned subsidiary of RBC and BBAM LLP may be considered to be related and/or connected to RBC and its other affiliates. ® Registered trademark of RBC. RBC GAM is a trademark of RBC. BlueBay Funds Management Company S.A., registered office 4, Boulevard Royal L-2449 Luxembourg, company registered in Luxembourg number B88445. BlueBay Asset Management LLP, registered office 77 Grosvenor Street, London W1K 3JR, partnership registered in England and Wales number OC370085. The term partner refers to a member of the LLP or a BlueBay employee with equivalent standing. Details of members of the BlueBay Group and further important terms which this message is subject to can be obtained at www.bluebay.com. All rights reserved.

Sign up for insights by email

Subscribe now to receive the latest investment and economic insights from our experts, sent straight to your inbox.