Patricia Ribeiro - Trailblazing through Emerging Markets

EMD: Reframing the External vs. Local Debt Debate for 2021


EM currency outlook might bode well for local assets.

KEY TAKEAWAYS

  • The historical outperformance of external debt has led emerging markets debt (EMD) investors to overweight external debt compared with local debt.
  • We believe the U.S. dollar cycle has turned, which could reshape how investors allocate to EMD.
  • We believe currency appreciation and yield will be the main sources of EMD return in 2021.
  • Viewing EMD through a factor lens may improve traditional EMD allocation decisions.
  • Given the historical volatility of EMD, we believe factor performance warrants a broader and more flexible approach.

Past Performance: A Guide for the Future?

Asset manager data demonstrate investors’ preference for EM external debt over EM local debt. According to eVestment, as of 31 December 2020, the universe of local currency managers had $121 billion in assets under management (AUM). The equivalent for external debt (excluding corporates) was $332 billion. The same picture is evident in many blended managers’ allocations, where biases toward external debt are common in the choice of strategic benchmarks and tactical allocations. So, what explains this bias? We can quickly find its roots in historical index performance. See Figure 1.

Figure 1 | External and Local Index Returns, Volatility and Risk-Adjusted Return Since 2002

Asset Class Reference Index Annualized Return Annualized Volatility Sharpe Ratio
EMD External JPM EMBI GD 8.17% 8.58% 0.95
EMD Local JPM GBI-EM GD 6.72% 11.83% 0.57

Data from 31/12/2002 - 31/12/2020. Source: Bloomberg.

Figure 1 | External and Local Index Returns, Volatility and Risk-Adjusted Return Since 2002

Data from 31/12/2002 - 31/12/2020. Source: Bloomberg.

Figure 1 | External and Local Index Returns, Volatility and Risk-Adjusted Return Since 2002

Asset Class Reference Index Annualized Return Annualized Volatility Sharpe Ratio
EMD External JPM EMBI GD 8.17% 8.58% 0.95
EMD Local JPM GBI-EM GD 6.72% 11.83% 0.57

Data from 31/12/2002 - 31/12/2020. Source: Bloomberg.


The data appear to present a compelling case in which external debt not only outperformed local debt, but it does so with lower volatility. However, the divergence in performance is almost entirely due to the underperformance of EM FX since 2010. We believe EM FX will outperform in coming years, a factor that could help reshape investor allocations to EMD.

Five Ways EM Could Outperform in 2021

We believe the U.S. dollar cycle turned as of September 2019. This factor combined with rising commodity prices may help EM FX outperform duration and credit in coming years. If correct, investors might consider rethinking their allocations. We base our view on five arguments.

1. Valuation Points to Dollar Decline

The U.S. dollar is overvalued relative to its long-term average. Historically, dollar peaks have been followed by multi-year dollar depreciation, as Figure 2 highlights.

Figure 2 | U.S. Dollar vs. Average Real Effective Exchange Rate

Data from 31/10/1980 - 31/12/2020. Source: Bloomberg.

2. Dollar Tracks U.S./World Growth Differential

Dollar cycles have historically lasted between seven and 10 years, because they tend to track the growth differential between the U.S. and the rest of the world. See Figure 3. Recent fiscal stimulus from the Trump administration boosted growth in the short-term, but the resultant fiscal deficit will weigh on future growth. The COVID-19 crisis has amplified this trend.

Figure 3 | U.S. Dollar and U.S. vs. World Growth

Data from 31/10/1980 – 31/12/2020. Source: Bloomberg.

Past performance is no guarantee of future results.


3. Deficits Drive Down Dollar

Historically, the size of the U.S. fiscal and current account deficits—the nation’s twin deficits—have influenced the dollar’s value. Figure 4 tracks this relationship. In 2020, the sum of the twin deficits ballooned from 8% of GDP to 17% of GDP.

Figure 4 | Sum of U.S. Fiscal Deficit Plus Current Account Deficit vs. Dollar Index

Data from 31/10/1980 - 31/12/2020. Source: Bloomberg.

4. Monetary Policy Weakens Greenback

To fight the recessionary and deflationary effects of COVID-19, the Fed oversaw the largest expansion in the U.S. money supply since World War II, as Figure 5 illustrates. This action is likely to drive inflation higher and the U.S. dollar lower over time.

Figure 5 | Federal Reserve Money Supply M2 vs. Inflation in the U.S.

Data from 31/10/1980 - 31/12/2020. Source: Bloomberg.

5. Rising Commodities Benefit EM FX

Historically, rising commodity prices have correlated with gains in EM FX, as Figure 6 demonstrates. The outperformance of China’s economy, coupled with the huge monetary stimulus depicted above, should cause commodity prices to reflate in 2021 and beyond. Commodity exports remain an important source of earnings for many EM countries and therefore influence EM FX. 

If our thesis proves correct, the appreciation of EM FX will cause local debt to outperform external debt in coming years. This could lead to a major rebalancing of investor portfolios away from external debt.

Figure 6 | Commodities Still Far From Recent Peaks and May Bode Well for EMFX

Data from 31/10/1980 - 31/12/2020. Source: Bloomberg.

Past performance is no guarantee of future results.


Could EMD Outperform in 2021?

Monetary and fiscal policy stimulus within EM countries expanded significantly in 2020, causing fundamentals to deteriorate. Meanwhile, credit spreads have nearly returned to their pre-pandemic levels. We believe this spread retrenchment will limit returns among external debt securities.

Volatility in EM credit also picked up materially in 2020, leaving risk-adjusted returns less compelling than in prior years.

Furthermore, we believe the Fed will keep interest rates close to 0% in 2021, which will limit the gains available from duration. This rate policy may also limit the potential gains from local rates in 2021.

While investors still may be able to profit from security selection within the local rates and EM credit segments, we believe caution is warranted in allocating to these securities. We expect EM FX appreciation coupled with yield to drive EMD returns in 2021.

Beyond External and Local: A Factor-Based View

Many investors consider EMD allocation decisions as exercises in timing exposure in external bonds versus local securities. We believe allocation decisions merit greater consideration, and investors might improve their strategies by viewing the EMD universe through a factor lens.

From a factor perspective, EM external debt consists of U.S. duration and credit exposure. EM local debt consists of local rates duration and FX exposure. Because U.S. duration and local rates duration have been highly correlated in aggregate, we can simplify the decision-making framework into three factors: duration, credit and FX.

Figure 7 shows the historical contribution of each factor to the price performance of a 50% external/50% local blended index.

Figure 7 | EMD Factor Contribution to Price Performance Since 2002

Data from 31/10/1980 - 31/12/2020. Source: Bloomberg.

Could EMD Outperform in 2021?

Monetary and fiscal policy stimulus within EM countries expanded significantly in 2020, causing fundamentals to deteriorate. Meanwhile, credit spreads have nearly returned to their pre-pandemic levels. We believe this spread retrenchment will limit returns among external debt securities.

Volatility in EM credit also picked up materially in 2020, leaving risk-adjusted returns less compelling than in prior years.

Furthermore, we believe the Fed will keep interest rates close to 0% in 2021, which will limit the gains available from duration. This rate policy may also limit the potential gains from local rates in 2021. 

While investors still may be able to profit from security selection within the local rates and EM credit segments, we believe caution is warranted in allocating to these securities. We expect EM FX appreciation coupled with yield to drive EMD returns in 2021.

Beyond External and Local: A Factor-Based View

Many investors consider EMD allocation decisions as exercises in timing exposure in external bonds versus local securities. We believe allocation decisions merit greater consideration, and investors might improve their strategies by viewing the EMD universe through a factor lens.

From a factor perspective, EM external debt consists of U.S. duration and credit exposure. EM local debt consists of local rates duration and FX exposure. Because U.S. duration and local rates duration have been highly correlated in aggregate, we can simplify the decision-making framework into three factors: duration, credit and FX.

Figure 7 shows the historical contribution of each factor to the price performance of a 50% external/50% local blended index.

Figure 7 | EMD Factor Contribution to Price Performance Since 2002

Data from 31/10/1980 - 31/12/2020. Source: Bloomberg.

Figure 7 demonstrates that no single factor has outperformed consistently. Credit was the best-performing factor for most time periods, but the market moves in 2020 left duration as the factor with the highest cumulative return. Although FX was the clear laggard since 2010, it was the best-performing factor in 2007.

The role of EM FX in shaping the external versus local debate becomes evident. For the period in which EM FX was generally appreciating, up to 2010, external and local debt displayed different outcomes. Figure 8 outlines the performance trends between 2002 through 2010.


Figure 7 demonstrates that no single factor has outperformed consistently. Credit was the best-performing factor for most time periods, but the market moves in 2020 left duration as the factor with the highest cumulative return. Although FX was the clear laggard since 2010, it was the best-performing factor in 2007.

The role of EM FX in shaping the external versus local debate becomes evident. For the period in which EM FX was generally appreciating, up to 2010, external and local debt displayed different outcomes. Figure 8 outlines the performance trends between 2002 through 2010. 

Figure 8 | External and Local Index Returns, Volatility and Risk-Adjusted Return

Data from 31/12/2002 - 31/12/2010. Source: Bloomberg.

Past performance is no guarantee of future results.

 

Figure 8 | External and Local Index Returns, Volatility and Risk-Adjusted Return

Asset Class Reference Index Annualized Return Annualized Volatility Sharpe Ratio
EMD External JPM EMBI GD 10.66% 9.33% 1.14
EMD Local JPM GBI-EM GD 13.64% 11.47% 1.19

Data from 31/12/2002 - 31/12/2010. Source: Bloomberg.
Past performance is no guarantee of future results.


These historical results support the view that local debt is more volatile than external debt. However, the Sharpe ratios for the period indicate EMD investors were more than compensated for this additional volatility, as local debt outperformed external debt by nearly 3% per annum.

In the period from 2010 to 2019, the rebalancing of the China growth model not only led to slower GDP growth but declining commodity prices. The gradual tightening of U.S. monetary policy from 2013 helped the U.S. dollar appreciate relative to other currencies, particularly EM FX. The combination of these headwinds is reflected in the EM FX underperformance seen previously in Figure 1. This, in turn, explains why external debt outperformed local debt from 2010 to 2020. 

Implications for EMD Allocation

Although our thesis argues for the outperformance of local debt over external debt, we favor a more nuanced view of EMD allocation. Given the frequent rotation of leadership in EMD factors, we believe a factor lens has higher efficacy in allocation decisions.

Our macroeconomic framework has demonstrated high explanatory power in the direction of EMD returns and in informing asset allocation decisions. Therefore, we favor a broad and flexible view of EMD allocations as part of an all-weather approach to investing in the asset class.

EMD: Reframing the External vs. Local Debt Debate for 2021

EMD: Reframing the External vs. Local Debt Debate for 2021

Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.

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