Many EMD investors believe that the overvaluation of the US dollar is at relatively extreme levels, while growth in emerging markets is higher than in more developed markets. Moreover, most emerging markets also managed to reduce inflation faster, and positive momentum seems to be building in credit ratings and broad fundamentals. Still, this did not translate into nice returns over the first half of 2024.
While the Morningstar Emerging Markets (EM) Government Bond Local Currency index still closed the first quarter in the plus, emerging market local currency bonds corrected by 1.2 per cent measured in euro over the past three months, while emerging market hard currency bonds, as measured by the Morningstar EM Sovereign Bond index, ended the first half of 2024 with a positive return of 3.4 per cent. The yield differential for the average fund in the respective categories was a whopping 7.2 percentage points over the past 12 months.
This is mainly a currency effect driven by a strong US dollar. Meanwhile, expectations at the beginning of this year that the Federal Reserve would cut interest rates multiple times have been adjusted, prompting central bankers in emerging markets to be more cautious. After all, aggressive monetary policy easing without the Fed’s ‹blessing› could potentially put pressure on local currencies. Ultimately, elections also often caused increased volatility.
Indonesia under fire
This was the case for Indonesia, for example. This year, the Indonesian rupiah weakened due to the current account deficit and fears that the future policies of newly elected president Prabowo Subianto could further damage the budget. At the end of June, the USD/IDR exchange rate stood at 16.343, or 6.2 per cent higher than at the start of this year.
However, these market developments do not deter the president, who is confident that his ambitious programme will eventually lead to increased tax revenues. Economists warn that the debt ratio could rise from 39 per cent to 50 per cent of GDP in the process, but the government denies this and makes the case that the country can maintain its investment-grade rating.
Current government debt levels, along with Vietnam’s, are among the lowest in Southeast Asia, but Indonesia has a relatively high interest burden. Besides infrastructure works, the plans include a free lunch programme for schoolchildren and are a major shift from the previously conservative fiscal stance of previous president Joko Widodo.
The currency devaluation came anyway, despite Bank Indonesia’s discipline. The central bank raised the policy rate in steps to 6.25 per cent in April this year (from 3.50 per cent in mid-2022) and successfully managed to reduce inflation to 2.5 per cent in June.
Viewed differently
The asset class comes out better when we measure its performance against European government bonds. Indeed, the Morningstar EM Government Bond Local Currency index showed an annual average return of 2.2 per cent in euro terms over the past decade compared to just 0.4 per cent for the Morningstar Eurozone Treasury Bond index. This has much to do with the 18.2 per cent correction in 2022 while emerging-market local-currency bonds were down just 4.6 per cent. The current index initial yields are 5.9 per cent and 2.7 per cent respectively for emerging-market and European bonds.
The question is whether this extra return is enough to compensate for the greater uncertainty and exchange rate risks. Indeed, volatility measured by the standard deviation has been significantly higher for Morningstar EM Government Bond Local Currency than for European bonds (5.51 per cent) and in line with that for emerging-market hard currency bonds (8.5 per cent) over the past decade at 8.15 per cent.
Investors in EMD are still mainly trying to benefit from growth in emerging markets as well as increasing allocations due to local institutional investors such as insurance companies and pension funds, as they do not really see the asset class as an alternative to their bonds in more developed markets.
Morningstar Fund Radar: Capital Group
In the qualitative opinion of our fund analysts, the strategies that appear prominently on Morningstars radar either have a strong management team and a robust investment process, or are attributed these qualifications based on an algorithm that evaluates mutual funds based on the same framework. In this article, we highlight a fund that meets these criteria and is followed by Morningstar analysts.
Investors in Capital Group Emerging Markets Local Debt continue to benefit from experienced leadership and a robust research team, resulting in an Above Average People pillar rating. Until October 2023, the strategy was led by the experienced Kirstie Spence, Robert Neithart and Luis de Oliveira, who, in good Capital custom, independently managed separate portions of the portfolio.
However, Neithart stepped down from the strategy in October, only to retire two months later. Instead of replacing Neithart with another manager, the fund house handed over its portion of the portfolio, comprising about 20 per cent of total assets, to the EMD analyst team of seven. That ‹research portfolio› is a collection of best ideas, while Spence and de Oliveira split the remaining assets equally. As principal investment officer (PIO), Spence ensures that the combined portfolio stays within the guidelines of the mandate. Given the specific strategy, the team is further supported by dedicated traders.
The investment process combines top-down macroeconomic insights with bottom-up fundamental analysis. The bulk of assets are invested in local currency bonds, but the team has room to invest outside the benchmark where it sees opportunities.
Hard currency bonds are limited to 20 per cent of total assets and up to 30 per cent of currency exposure can be hedged in US dollars or euros. The duration, a measure of a portfolio’s interest rate sensitivity, is kept within a year of that of the JPM GBI-EM Global Diversified benchmark and the team therefore tries to add the most value through country selection. With success, as over the past 10 years, the fund has beaten more than 80 per cent of its direct competitors as well as the Morningstar EM Government Bond Local Currency category index.
Thomas De fauw is manager research analyst at Morningstar. Morningstar analyses and evaluates investment funds based on quantitative and qualitative research. Morningstar is one of Investment Officer’s knowledge partners.