Opportunities in Emerging Market Local Currencies
Market reversal – local currencies poised to benefit: Emerging markets local currencies have borne the brunt of the emerging markets selloff following the election. In addition to the significant appreciation in the U.S. dollar over the past few weeks, concerns about the impact of Trump’s campaign proposal on specific countries, such as Mexico, have weighed on currency valuations. By historical measures, many emerging markets currencies were already cheap prior to the election, and since then have sunk to levels not seen since the financial crisis in early 2009. Given these levels, any sign that the Trump agenda (as it relates to emerging markets) has stalled, been sidetracked, or will be ineffective, may boost local currencies.
Other items on Trump’s agenda could benefit emerging markets local currencies. Much of the market impact from Trump’s win has been attributed to expectations of an inflationary infrastructure spending program. Many emerging markets currencies are closely linked to commodity prices, which could benefit under this scenario. In addition, the recent OPEC (Organization of Petroleum Exporting Countries) production deal may keep oil prices higher, helping to support the currencies of oil exporters such as Russia, Colombia, and even Mexico.
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Low visibility – hold the entire market: The effects of Trump’s win, and more broadly, changes in economic and geopolitical outlooks, tend to impact the various sectors within emerging markets bonds differently. For example, local currency bonds have recently exhibited larger drawdowns versus hard currency bonds, while corporate bonds have outperformed as tighter spreads offset the impact of higher interest rates. Deciding where to allocate within emerging markets bonds is an active decision that can significantly affect an investor’s risk/return profile, and given the lack of clarity that currently exists, this can be extremely challenging. As an alternative, investors may prefer to have broad beta exposure to the entire emerging markets bonds opportunity set, and potentially benefit from the inherent diversification within the asset class.
With currency in a tailspin, what about investing in emerging market bond funds?
The VanEck Vectors EM Local Currency Bond ETF (EMLC) tracks currency-denominated emerging market bonds. It could prove to be a good entry point for investors after it took a hit following rising interest rates and the volatility of the US dollar.
EMLC holds net assets worth more than $2.7 billion and has a duration of 4.9 years. It also has a 30-day SEC (U.S. Securities and Exchange Commission) yield of 5.8%.
As you can see in the above graph, the VanEck Vectors EM Local Currency Bond ETF (EMLC) started lagging behind the iShares JPMorgan USD Emerging Markets Bond (EMB) in the latter part of 2014. It has shown signs of recovery in the last year.
Year-to-date, EMLC has risen 3.1% compared to a 1.3% rise in EMB during the same period. That signals a sign of resurgence for EMLC, which has already had a stellar performance so far.
Going forward, a weakening US dollar compared to the Brazilian real, the Mexican peso, and the Polish zloty will contribute to the future performance of EMLC. Strengthening emerging market (PCY) (EMAG) (IGEM) currencies or a weakening US dollar (UUP) should continue to bolster returns from local currency emerging market bond ETFs.
In the next part of this series, we’ll examine the performance characteristics and the potential benefits of investing in emerging market bonds from a portfolio construction perspective.