Tide Shifting to Support EM Local Currency Bonds

For much of the past four years, including most of this year, the strength of the U.S. dollar has been a headwind for emerging markets (EM) assets, including local currency sovereign bonds. Although the asset class has outperformed broad U.S. and global investment grade bonds, investor sentiment has been weak based on investment flows. This is despite very favorable fundamentals relative to developed markets. With favorable growth and fiscal trends, controlled inflation and high levels of real interest rates, all on top of a significantly lower gross debt-to-GDP ratio, the case for EM local currency bonds has been strong, in our opinion. The change in the rate cycle in the U.S. and the magnitude of new Chinese stimulus measures further strengthen the case, and we believe it’s time for investors to consider an allocation to EM local currency bonds within their global bond portfolio.

Easing monetary policy in the U.S. removes a headwind that has been in place since the Fed began hiking aggressively in 2022. A soft landing in the U.S., which remains a likely scenario over the next six to twelve months, provides a “goldilocks” scenario of lower rates and support for economic growth. In China, new fiscal and monetary stimulus along with new measures to stimulate the domestic property market were announced. The dynamics taking place in the world’s two largest economies are positive for global growth, and many of those benefits could accrue to emerging markets. For example, commodity sensitive currencies could benefit from higher growth. In that category, Latin American currencies have been the worst performers in the J.P. Morgan GBI-EM Global Core Index this year, providing upside potential in our opinion, particularly given that the new measures in China took the market by surprise. Latin America accounts for more than 25% of the index.

EMFX Year-to-date Performance (as of 9/30/2024)

Source: J.P. Morgan as of 9/30/2024. Index performance is not representative of strategy performance. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

Longer term, we could expect emerging markets to continue to compare favorably overall to the U.S. and other developed markets from a fundamental perspective. U.S. government spending and borrowing trends are, in our view, highly unfavorable for the U.S. dollar. The continued monetary and fiscal stimulus also suggests that there could be higher inflation than we had seen the decade prior to the Covid-driven shock, and that may benefit commodity producers.

EM local currency sovereign bonds are generally considered a “risk-on” asset class, despite these favorable fundamentals, which exposes the asset class to certain technical risks in the near term. Geopolitical instability and a harder landing in the U.S. than currently anticipated are the most obvious risks. However, we believe the long-term fundamentals can make the asset class attractive, particularly as we move into a period of Fed easing, stimulus measures being implemented globally and a weaker or stabilized U.S. dollar.

Important Information and Risk Disclosure

Investing in emerging market (EM) local currency bonds involves significant risks, including but not limited to currency fluctuations, geopolitical instability, and economic uncertainties. While the asset class may offer attractive opportunities, investors should be aware that past performance is not indicative of future results. The value of investments and income derived from them may fluctuate, and investors may not recover the full amount invested. This material is for informational purposes only and does not constitute investment advice or an offer to buy or sell any securities. Investors should consider their individual investment objectives and risk tolerance before making investment decisions.

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