State Street SPDR ETFs: Outlook for Emerging Market Debt improves

20 september 2024

The monthly return of 3.4%, as measured by the Bloomberg EM Local Currency Liquid Government Index, was the strongest so far this year, and was largely driven by currency returns which accounted for 2.4% of the total. Currency gains were the flip side of US dollar (USD) weakness as the trade-weighted USD, as measured by the US Dollar Index, declined 2.3%.

However, the picture was a little more nuanced with some EM currencies suffering from the unwind of carry trades early in the month. This most notably impacted the high yielders with Mexico, Turkey, and Columbia all suffering negative returns. Bond returns were also positive overall, consisting of 0.4% gains from coupon flows and 0.6% from price returns. 

The Federal Reserve clears the air

The key catalyst for these gains was the Federal Reserve (Fed) signalling a willingness to start the policy easing cycle in September. Weaker US data has also supported the view that cuts are imminent. However, in spite of markets pricing in more extreme cuts from the Fed since the start of September, EMs have failed to build on August gains. Fears of a broader slowdown have induced some market caution over risk assets, but reasons to like EM local currency debt market exposure remain: 

• The rate cut process is underway in emerging markets, though questions surrounding when the Fed would start to cut rates has been restraining the actions of EM central banks. While cuts are needed to support the economy, there are risks inherent with easing policy too quickly versus the profile of US rates, as this can weaken a currency and potentially raise inflation. The Fed is expected to start the process of lowering US rates at the meeting on 18 September, so those EM central banks that need to can resume their policy easing cycles. 
• The USD has been the key unknown for local currency investors. Despite recent declines, it remains 11.5% overvalued versus the basket of currencies that make up the Bloomberg EM Local Currency Liquid Index — but this has been the case for the past five years and has proven no guarantee that it will weaken. With policy easing in play, it is likely to undermine one pillar of support for the USD: the higher yield advantage over many other currencies that US Treasury investors enjoy. There are other factors that may weigh on the USD as well, such as US political uncertainty. 
• There were also currency risks embedded within EMs with several, most notably the Mexican peso, being the currency of choice for carry trade investors. The unwind of many of the carry trade positions in early August substantially diminishes the overweight of allocations to some of these high yielding currencies.
• Coupon remains an important component of returns. Year to date, they account for a return of around 3.4% which implies close to 5% for the year as a whole. 

Jason Simpson, Senior Fixed Income Strategist at State Street SPDR ETFs:

'There are, of course, always idiosyncratic risks in emerging markets — and September typically has not been a strong month for bond markets in general. So while EM exposures can prove volatile, a key advantage is that they can provide strong running yield potential for portfolios. Nominal yields in EM bonds are comfortably higher than for developed markets, even some of the lower-rated credits.

While this has often been the case historically, the fact that EM central banks were aggressive in dealing with higher inflation early means that this is now also true for real yields. The average real 10-year yield weighted by the 18 countries in the Bloomberg EM Local Currency Liquid Index is 2.8% against 0.9% for US Treasuries and 0.3% for German Bunds.

There are also signs of a decoupling from US Treasuries, with the six-month weekly rolling correlation dipping to 40% from highs in March 2024 of over 87%. So EM debt could act as a risk diversifier.'