MFS: The Stars are Aligning
MFS: The Stars are Aligning
By Ward Brown, Fixed Income Portfolio Manager, and Benoit Anne, Managing Director - Investment Solutions Group, both working at MFS.
Over the past 20 years, emerging market (EM) local debt has been through several cycles. Each cycle has four stages. The fourth stage of the cycle has generally been associated with robust performance of EM local debt. As we approach the fourth stage, we believe that scaling up EM local debt exposure could be an attractive option for investors.
EM local debt is a cyclical asset class because local debt and currency valuations are impacted by central bank policy rates which are being continually adjusted to local business cycle conditions. In turn, EM local business cycle conditions are sensitive to the US business cycle, though the degree of synchronicity varies from cycle to cycle. The typical EM local debt cycle is characterized by four stages (See Exhibit 1):
- The US Federal Reserve begins a hiking cycle. Often at this stage in the cycle, EM monetary policy has become accommodative which supports EM growth and contributes to a widening of EM current account deficits.
- EM local bonds and currencies weaken as the Fed’s hiking cycle continues. This prompts EM central banks to start hiking interest rates to stabilize currencies and fight inflation.
- Growth slows and the Fed pauses its hiking cycle. Corporate earnings slow together with growth and risk appetite tends to weaken. The weakness in risk appetite puts additional pressure on EM currencies which forces EM central banks to continue hiking rates. The growth slowdown in this stage could be either a soft or hard landing. Which outcome occurs depends on several factors, one of which is the length of the Fed pause. In 2016, the Fed paused after only one rate hike and in 2019 the Fed began to signal rate cuts very early after its final hike in December 2018. Both these episodes resulted in soft landings, though the latter soft landing was then overtaken by the pandemic.
- Fed policy switches to dovish and rate cuts begin. This helps to stabilize risk appetite and lay the foundation for a growth recovery. EM currencies appreciate, inflation decelerates and real yields on local currency debt increase which helps to attract capital inflows. Eventually, EM central banks begin easing monetary policy. This stage has generally been associated with robust performance, local debt performs, rates fall and currencies appreciate.
