Outlook for emerging market local bonds

The tide is turning in favour of emerging market (EM) local currency bonds.

In the face of the global financial rout triggered by President Donald Trump’s tumultuous first 100 days in office, the long-term prospects for the asset class have been steadily improving.

Favourable valuations, high carry, loosening monetary policy and the growing probability of a long-term decline in the US dollar are supportive. All of which suggest EM local currency should feature more prominently in global fixed income portfolios.

Some investors might find reasons to be cautious. Recent years haven’t been kind to the asset class after all. Due to the Covid crisis and the Ukraine war, EM local currency bond funds suffered outflows.

But several trends now seem to be firmly moving in their favour.

Take the US dollar. Its uncontested run of the past few years, supported by US exceptionalism, has been the single biggest negative contributor to the performance of EM local debt. Now, though, the greenback stands on shakier foundations. In our view, it has entered a period of structural weakness, not least because of the uncertain policy backdrop in the US.

Our fair value model shows that the dollar is 20 per cent overvalued against emerging market currencies relative to its long-term average.Based on relative prices, relativeproductivity and net foreign assets, average of 31 emerging currencies

We believe this gap will narrow in the coming years, just as GDP growth differentials between emerging and developed economies widen further from the current 14-year high.

A weaker dollar should act as a magnet for international capital for emerging markets. Recent market turmoil emanating from the US has already encouraged investors to gradually diversify portfolios that had become too reliant on American assets. Data from the Bank for International Settlements shows that one standard deviation depreciation in the US dollar against advanced economy currencies in any one month increases investment flows to local currency EM bonds by as much as 0.29 percentage points.https://www.bis.org/publ/qtrpdf/r_qt2409d.htm

Aside from benign moves in the dollar, we also expect monetary conditions to loosen in favour of emerging economies, drawing in even more capital into local bond markets. Already, three quarters of the world's major central banks are easing monetary policy, with the three biggest – the US Federal Reserve, European Central Bank and the People’s Bank of China – all providing stimulus.

The emerging world’s inflation dynamics are also positive. The inflation rate in emerging economies has been falling every year since 2022 and price pressures are likely to ease further this year. Our leading indicators and proprietary inflation momentum tools suggest that emerging market inflation will likely fall below that of developed markets in the months ahead.

This should allow interest rates to fall further and faster across the emerging world. Many emerging market policy rates are above what we consider to be neutral levels (see Fig. 1). This rate is the sweet spot where the cost of borrowing is neither too restrictive nor too stimulative. 

The real rate of the asset class – or the inflation-adjusted return investors can lock in – is likely to rise further from the current level, which is already well above its long-term average and that of developed market bonds.

Another boost to the asset class is China's economic recovery. China is beginning to see the fruits of a slow rebalancing of its economy in favour of domestic consumption. At the same time, Beijing has pledged to use fiscal and monetary policy levers in its toolkit to help offset the negative impact from US tariffs. The positive effect will spill over to the rest of the emerging world, particularly developing economies in Asia, which are China's largest trading partners and, just as importantly, represent nearly half of the EM local currency benchmark bond index.

With macroeconomic and structural factors all moving its in favour, it is time for investors to look again at EM local currency bonds.