By Jason Conway, BNY Mellon Investment Management EMEA
A recent market correction in the emerging market local currency debt sector (EMDLC) belies potential future growth opportunities in the asset class, says Standish managing director and emerging markets debt team leader Federico Garcia Zamora.
After a strong start to the year the emerging market local currency debt sector has given up significant gains in recent months, thanks partly to a strengthening US dollar and the negative impact of a range of local geopolitical factors.
According to Standish’s Federico Garcia Zamora the EMDLC asset class has recently experienced a 6% correction in US dollar terms1 - against the JPM GBI EM Global Diversified Index - since its peak earlier in September amid some substantial market sell-offs.
“There is no doubt we have witnessed a major market correction in the past two months,” he explains. “The drivers of the sell-off have mainly been external but a few idiosyncratic risk stories have also raised considerable noise and nervousness in some markets.”
Garcia Zamora believes higher US interest rate expectations, growing perceptions the US Federal Reserve (Fed) will adopt a more hawkish stance in future and rising growth and inflation expectations, tied to mooted US tax reform, have been key drivers of changing market sentiment in EMDLC.
He also notes increased volatility in some major emerging markets such as South Africa, Mexico and Turkey has added to recent market uncertainty.
“Concern over upcoming elections to the ANC ruling party leadership in South Africa, fears about the pending outcome of the North American Free Trade Association (NAFTA) renegotiation agreements for Mexico and inflationary pressures and political volatility in Turkey have all had a negative impact on these markets in recent months,” he adds.
However, despite the recent correction in the EMDLC market, Garcia Zamora remains positive on the asset class and believes a wider market rebound could present significant investment opportunities, in the context of a medium- to long-term trend. Despite the abrupt change in mood in the past two months history shows that sentiment can change quite quickly.
“If one looks at the big picture the environment for the asset class looks brighter. The external forces that drive the asset class - global interest rates, commodities, and US Dollar levels - are materially more supportive than a couple of years ago. We actually expect US rates to continue to move higher from here, though the bulk of this move is likely behind us and we expect the remainder will also most likely be very gradual.
“Commodity prices have also rebounded strongly. In 2018 we expect them to be stable to slightly higher than current levels. In turn, we believe the US Dollar has peaked and will continue to depreciate over the medium term,” he says.
Garcia Zamora also believes the current risks facing South Africa, Mexico and Turkey are of a short-term nature and that these markets can overcome current political and economic hurdles in the months ahead.
“Across these three countries politics is driving the market and injecting uncertainty into them. Uncertainty introduces a risk premium in asset pricest. Asset prices build a risk premium across the curve and across asset prices. But once uncertainty dissipates that risk premium disappears too. In the medium term, political stability in South Africa and Turkey and a successful conclusion to the NAFTA renegotiation are far from inconceivable and all would bring some calm back to these markets,” he adds.
Commenting on wider resilience levels across the EMDLC asset class, Garcia Zamora adds: “It is important to remember that while some countries are experiencing difficulties, on average over the past three years the EMDLC universe has improved its fundamentals as inflation pressures are materially lower and balance of payment accounts are generally in better shape to withstand external shocks.
“Once the uncertainty related to Fed policy and Tax Reform in the US dissipates over the coming weeks we believe EMDLC will resume its upward trajectory supported by the constructive external environment and improving domestic fundamentals. In our view the main external drivers of the asset class seem to be more supportive of the space going forward.”
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1JPM GBI EM Global Diversified Index as at November 15, 2017.
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