Until very recently, emerging market (EM) dollar denominated bonds were priced such that they offered only narrow spreads over U.S. Treasuries. Some major market participants have implied that such valuations are reasonable, suggesting that EM bonds - including those denominated in foreign currencies - are safe havens from the malaise of the developed world economies.1
Since the financial crisis of 2007, global bond investors have flocked to emerging markets to benefit from stronger corporate balance sheets, substantial foreign currency reserves and better expectations for growth. Currency traders joined the capital flow - until recently the long emerging market currency / short U.S. dollar trade has been an attractive one.
It’s natural to seek safe haven in a currency other than the U.S. dollar given the fiscal difficulties that exist in the U.S., combined with low expectations for growth. EM currencies would appear to be a viable candidate, as the fundamental underpinnings of most currencies have improved materially over the past two decades. This improvement makes those currencies an attractive, but ultimately still speculative, bet: it does not mean that fixed income securities denominated in EM currencies can function as an alternative safe haven. These markets remain relatively illiquid, thinly-traded and inherently volatile.
Having lived and worked through significant financial cycles in Asia, I think it is wise to remember how investor sentiment drives capital flows and how potential market dislocations can arise from sudden changes in that sentiment. In the Asian currency crisis of 1997, investors lost confidence in those economies dependent on foreign debt to finance economic growth. This exposed their economies to significant foreign exchange risk. In 1997, the Thai Baht was the first Asian currency to “un-peg” from the U.S. dollar and devalue, quickly followed by the Indonesian rupiah and other neighboring currencies. Financial dislocation bled to domestic instability as Indonesian President Suharto was forced to step down after 30 years in power, amidst rioting in the streets of Jakarta. Mexico experienced a similar reversal of investor sentiment in 1994 resulting in interest rates of 80% and $28 billion in foreign reserve losses.
On September 17, the Economist noted EM bonds, even those denominated in local currencies, were “Teflon” - able to shrug off global fears.3 Only two weeks later, the picture reversed sharply as investors retreated and major emerging market currencies experienced significant selling pressure, in particular the Brazilian real, Mexican peso and the South African rand.4 On September 22, emerging market equities plunged 4% as yields on emerging market dollar-denominated bonds surged to a spread 400 basis points over U.S. Treasuries for the first time since June 2009.
Slowing global growth and a continuing EU debt crisis will weigh on export led economies. The potential for a liquidity squeeze, while perhaps more remote than it was two decades ago, remains a tangible concern. Rapid unwinding of short U.S. dollar positions as the dollar strengthens may add additional pressure to emerging market currencies.
A portfolio may benefit from diversification in EM currencies at the margin; however, caution is still essential, especially if such exposure creates a substantial currency mismatch between an investor’s assets and liabilities. If EM spreads over U.S. Treasuries return to narrow levels, they may not adequately compensate for this speculative risk - at least not for an investor who seeks capital preservation and stable income generation.
Investors can distinguish between the fundamental health of EM credit – which is, as some have suggested, strong – and the still fragile currencies of those markets. Rapid unwinding of capital flows may do quick damage to local currency EM bonds, wiping out fixed income investors’ expectations for current income. EM credit denominated in U.S. dollars may be a viable alternative. EM currencies may offer desirable diversification, and they may even be a good investment – but they remain speculative, and should not be considered a safe haven.William Maeck
- The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
- PIMCO, “The Caine Mutiny (Part 2)” 1 May 2011
- EMBI - J.P. Morgan emerging market bond index denominated in US dollars
- The Economist, “Non-stick securities,” 17 September 2011.
- The Economist, “One more such victory,” 1 October 2011.