Analysis:Emerging market local currency debt could end decade-long drought as dollar wanes

CNA

5 hours ago

LONDON :A weakening U.S. dollar is lifting a long-neglected asset class - emerging market local currency debt - after a more than decade-long drought.
Emerging market local​-​currency bond funds saw a new record of inflows in the week to Wednesday, according to EPFR data, notching eight straight weeks of inflows.
The nascent flows remain small - and the uncertainty of tariffs, war and other global turmoil are stemming some flows.
But investors expect they will continue, giving a boost to local debt markets in large emerging markets from Brazil and Mexico to Indonesia and India.
"Many of the big emerging markets tell us about all the foreign buying of debt, and that is starting to pick up across some countries," said Jonny Goulden, head of emerging market fixed income strategy at JPMorgan.
"This could be a potential turning point."
Yields on the JPMorgan GBI Emerging Market local currency index are at their lowest since 2022 - partly a sign of flows of international cash. Emerging market local currency government bonds have enjoyed returns of more than 10 per cent since the start of the year - more than double the around 4 per cent delivered by the hard-currency peers, according to JPMorgan indexes.
The weaker U.S. dollar, and questions over the years-long U.S. exceptionalism trade - when investors parked cash in booming assets of the world's largest economy - is nudging international investors to look elsewhere for bigger returns.
The greenback slipped to its lowest level in more than three years last week.
Slower global growth - and lower interest rates across the developed world - are adding to the hunt for yields.
"The dollar is going to be much, much weaker. Bond yields or interest rates will fall - so there is a search for yield," said Luca Paolini, chief strategist at Pictet Asset Management. Emerging market bonds look set to be one of the main beneficiaries of that momentum, he said.
The dynamics combined are helping to end the foreign investor flight from emerging markets' local currency bonds that Goulden said has lasted for some 14 years.
In that time, JPMorgan estimates, the asset class has more than doubled from roughly $6 trillion to $13 trillion, with mainly local investors, and some global bond funds, buying.
David Hauner, head of global emerging markets fixed income strategy at Bank of America, said that after years of a dollar bull market, and the U.S. exceptionalism trade, allocations to emerging markets were "absolutely rock bottom" - and had much space to grow.
"This has been completely neglected for a long period of time, and now, people have to diversify," he said, adding he expected small but steady flows - and double-digit returns on local currency at the end of the year in dollar terms.
The money is part of the closely watched global effort on the part of some international investors to diversify away from U.S. dollar holdings, and U.S. assets, after years of outsized returns that lured the bulk of the world's cash.
"So far this year to date, local currency has performed very well," said Carlos de Sousa, portfolio manager at Vontobel. "That's a really direct, automatic effect" from the drop in the dollar.
The fact that most emerging market central banks are broadly on a rate cutting trajectory - even as the outlook for the U.S. Federal Reserve's actions remain more mixed - is also adding to momentum.
Phoenix Kalen, global head of emerging markets research at Societe Generale, called it "a rare moment of goldilocks for local assets."
Local currency bonds, Kalen said, offer "compelling value," including in the Philippines, Czech Republic, Hungary, South Africa, Turkey, Brazil and Colombia.
The current shift, Goulden, Hauner and others say, has not come close to reversing the years of outflows, and Hauner said it was more a "trickle" so far than a flood. But even small flows can have an outsized impact.
"EM as an asset class is much smaller. So if you take out 1 per cent from the U.S., that is basically the equivalent of 20 per cent in emerging markets. So the impact of this flow could be quite meaningful," Bank of America's Hauner said.