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Are we Entering a Stable and Reliable Era?

In our view, it is a watershed moment for emerging market local currency debt. The asset class has performed exceptionally well despite the challenging external environment over recent months, anchored by two factors. First, the credibility of emerging market central banks has never been higher; policymakers have been assertive, tightening far ahead of developed market contemporaries, as post-pandemic inflation pressure emerged. Second, emerging market treasury managers have heeded lessons from the past, reducing reliance on financing in hard currency debt; by prioritising issuance in local currencies, targeting deep-pocketed locals, most emerging markets have reduced their vulnerability to “hot” capital outflows. As a result, we believe there is a new dawn - emerging markets have matured into a reliable and stable asset class.

The key question: how will local currency emerging market debt evolve this year?

From a global growth perspective, we believe that emerging markets are in a good place. We do not subscribe to the narrative that the global economy is heading for a “hard-landing”. Sure, global growth is moderating, but any near-term slowdown will likely be shallow and temporary. The real story is that structurally, global growth is likely to remain buoyant, where we anticipate an elongated technology-led and rivalry-fuelled multi-year economic expansion led by the US and China. The emerging market economies are well placed to benefit from the spill-over from this growth dynamic. This view is shared by the most recent IMF forecasts, which raised growth premium for emerging economies relative to developed economies at around +2.5% over the next five years.

There is also much to like about the inflation calibration when it comes to the emerging markets. The great inflation surge has gripped the investment community over the last 18 months. It is no surprise that this inflation pressure showed up first in the emerging markets; many of these economies tend to be small, open, and highly sensitive to external factors. There is clear evidence that inflation has already peaked in emerging markets and is already in the process of rapidly decelerating in many cases. With inflation in the rear-view mirror, we believe that the vast majority of emerging market central banks have brought their tightening cycles to a close, with the market now pricing rate cuts over the course of next year for many. With peaking inflation and pivoting central banks, global capital is likely to be pulled back towards emerging market local currency debt.

fedra 1

Past performance is not a reliable indicator of future returns. Income from investments can be variable and not guaranteed.

Source: Eurizon SLJ Capital and Bloomberg as of 31st March 2023

fedra 2

Past performance is not a reliable indicator of future returns. Income from investments can be variable and not guaranteed.

Source: Eurizon SLJ Capital and Bloomberg as of 31st March 2023

The knock-on impact from assertive policy tightening in emerging markets is that local assets have built up a significant carry and valuation cushion. In the charts above, we can see exactly what is on offer when it comes to local currency emerging market debt. Starting with carry, in Figure 1, we can see the huge payoff on offer when holding emerging market currencies, relative to the dollar, over the next 12 months; the highest payoff is in LATAM (~6%) and CEE (~5%). The attractiveness of emerging markets local assets can also be seen in valuation terms, as outlined in Figure 2. Using our internal model, which takes an average of three PPP models (CPI/PPI/GDP), we can see the dollar is close to historical overvaluation relative to emerging markets currencies, at approximately 19%. The currency payoff is a crucial component to the total return of allocations to local currency debt; as such, we believe that the asset class will be supported, via the favourable annual currency carry and attractive valuations.

CONCLUSION: Looking ahead, we believe there will be plenty of opportunities in emerging market local currency debt, this year. While there are tail risks, with the noise in the US banking system and the geopolitical tensions in the East on our radar, we believe that we are in the midst of a new dawn for the asset class – a stable and reliable era.

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    This communication is issued by Eurizon SLJ Capital Limited (“ESLJ”), a private limited company registered in England (company number: 09775525) having its registered office at 90 Queen Street, London EC4N 1SA, United Kingdom. ESLJ is authorised and regulated by the Financial Conduct Authority (FRN: 736926). This communication is treated as a marketing communication intended for professional investors only and is provided only for information purposes. It has not been prepared in accordance with legal and regulatory requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. It does not constitute research on investment matters and should not be construed as containing any recommendation, advice or suggestion, implicit or explicit, with respect to any investment strategy or financial instruments, or the issuers of any financial instruments, or a solicitation, offer or financial promotion relating to any securities or investments. ESLJ and its affiliates do not assume any liability whatsoever for the contents of this communication, save to the extent agreed in any written contract entered into between ESLJ and the recipient, and do not make any representation or warranty as to the accuracy or completeness of any information contained in this communication. Views are accurate as at the time of publication. Opinions expressed by individuals are their own and do not necessarily reflect those of ESLJ or any of its affiliates. The value of any investment may change and an investor may not get back the original amount invested. Past performance is not an indicator of future performance. This communication may not be reproduced, redistributed or copied in whole or in part for any purpose. It may not be distributed in any jurisdiction where its distribution may be restricted by law and persons into whose possession this communication comes should inform themselves about, and observe, any such restrictions.