3 Charts Indicate the Emerging Markets Currency Surge May Be Ending

The emerging markets currency party

While investors in emerging markets (EEM) (VWO) continue to enjoy the surge in currencies so far this year, many are beginning to look for structural weaknesses. The WisdomTree Dreyfus Emerging Currency Strategy ETF (CEW), the WisdomTree Chinese Yuan Strategy ETF (CYB), and the Market Vectors-Indian Rupee/USD ETN (INR) are just a few of the listed funds invested in emerging markets currency. Returns from these funds so far this year are charted below:

Ticker Fund YTD Return (as of May 25)
CEW WisdomTree Dreyfus Emerging Currency Strategy ETF 6.55%
CYB WisdomTree Chinese Yuan Strategy ETF 4.6%
INR Market Vectors-Indian Rupee/USD ETN 8.79%

Local-currency debt has soared

The surge in emerging markets currencies is also behind the attractiveness of emerging market local-currency debt. The iShares Emerging Markets Local Currency Bond ETF (LEMB) and the Market Vectors Emerging Markets Local ETF (EMLC) have returned 8.2% and 6.9%, respectively, YTD (as of May 25). 2016 saw a record $506 billion of local-currency emerging market bond issuances, up 32.5% from 2015, according to Bloomberg data. And, we’re seeing investors continuing to pile into emerging market debt this year.

What could bring the rally to an end?

However, those invested in emerging markets currency remain watchful of the peak. Three things that could reverse the trend easily are:

  1. US growth (SPY) (IWM) momentum accelerating, leading to a stronger US dollar (UUP)
  2. Volatility in commodity prices
  3. Change in investor sentiment towards emerging market assets

 

In this series, we’ll review three charts which seem to signal that the emerging markets currency surge may be on it’s last leg. Let’s begin with the emerging markets currency-commodity spread, as discussed in the next part of this series.

The Greatest Risk Facing Latin American Economies Is the One We Cannot See

The risk we cannot see

Latin American equity has been a strong performer thus far this year. The iShares Latin America 40 ETF (ILF) has returned 12.7% so far this year (as of March 23), an outsized driver of emerging market (EEM) (VWO) performance. The rally, driven by the commodity price rebound has been instrumental in driving up the stock market. The market upswing and the continued preference for emerging market debt seems to indicate that investors in the Latin American economies are shrugging off the near-term risks posed by the Trump administration.

[stockdio-historical-chart stockExchange=”NYSENasdaq” width=”100%” symbol=”ILF” compare=”EEM” displayPrices=”Lines” performance=”true” from=”2017-01-01″ to=”2017-03-23″ allowPeriodChange=”true” height=”350px” culture=”English-US”]

Pockets of uncertainty

However, the greatest risk facing the Latin American economies is the one we cannot see, said Arthur Rubin, Head of Latin America Debt Capital Markets, SMBC Nikko Securities America, Inc., during a March 23 interview with Bonds & Loans. There remain pockets of uncertainty, says Rubin. “The new norm under the Trump administration maybe pockets of uncertainty, driven by unpredictable and unforeseen policy initiatives that don’t really last that long.” The markets are already pricing in the rate hikes expected in the U.S. However, in the event of a policy occurrence beyond the expected, emerging markets such as those placed in Latin America, stand more exposed to risk of possible repercussions.

Local-debt winning investor favor

While Rubin does agree that the volume of international debt issued globally is on the rise, he doesn’t see Latin American economies such as Colombia (GXG) (ICOL), Peru (EPU), and Chile (ECH), taking the plunge, just yet. Credit spreads, which are beginning to tighten for many economies, are still wide enough for certain LatAm economies.

Local currency emerging market debt is already flying high amid U.S. policy reshuffle. The current and expected U.S. policy reshuffle including monetary policy tightening, along with protectionist curbs are expected to strengthen the U.S. dollar (UUP), which works against holders of emerging market (EEM) (VWO) dollar-denominated debt which gets expensive with a rising dollar. This is when local-currency debt takes center stage as the instrument that is immune to such policy risk.

Local Currency Emerging Market Debt Is Flying High After U.S. Policy Reshuffle

Local-currency debt gaining preference

With improving fundamentals and reduced riskiness (as discussed in Part 1), emerging market debt continues to gain investor favor. Issuances reached a record high in 2016, with 2017 expected to break the record.

Another notable trend is the increasing number of investors that are piling into emerging market debt (EMB), with local-currency debt (LEMB) (EMLC) being preferred over dollar denominated debt. The current and expected U.S. policies reshuffle including monetary policy tightening, along with protectionist curbs. Both are expected to strengthen the U.S. dollar (UUP), which works against holders of emerging market (EEM) (VWO) dollar-denominated debt which gets expensive with a rising dollar. This is when local-currency debt takes center stage as the instrument that is immune to such policy risk.

Up 13.3% over the past year

Over the past year, the iShares Emerging Markets Local Currency Bond ETF (LEMB) has returned 13.3% (as of March 21), as compared to the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) which has yielded about 5%. Year to date, these ETFs are up 7.2% and 2.4%, respectively. The LEMB tracks a market-value weighted index of sovereign debt denominated in issuers’ local currencies. The emerging market bond investor’s preference is clearly towards local-currency bonds, as they are better immune to any interest rate hikes by the US Fed, as well as any protectionist directives issued by the Trump administration in the US.

So far in 2017, local-currency debt has provided double the returns provided by dollar-denominated emerging market debt. Investors have already invested about $4.5 billion into local-currency debt so far this year, according to EPFR Global.

Fund houses piling into local debt

About 41.5% of the LEMB fund is held by institutional investors. Schroder Investment Management Group, Blackrock Fund Advisors (BLK), and Morgan Stanley (MS) count amount the top 3 holders of the funds’ shares. According to Abdallah Guezour, a fund manager for Schroders emerging market debt, “investors should be flexible and opportunistic in local debt markets now.” For local debt, Guezour’s preference is towards Argentina (ARGT), Brazil (EWZ), Russia (RSX), South Africa (EZA), Indonesia (EIDO) and Mexico (EWW). Ashmore Group prefers Brazil’s local debt.

Man Group Plc (MNGPY), the leader in listed hedge funds, is investing in local-currency bonds. Units of BNP Paribas and JPMorgan Chase (JPM) have already turned bullish on local-currency debt.

We’re also seeing a number of sovereign issues from the emerging markets surfacing. Saudi Aramco is looking to raise $2 billion in riyal-denominated Islamic bonds (aka sukuk) in the second quarter of this year. The sukuk sale is said to be part of its $10 billion debt program. Nigeria is set to launch local currency green bonds in April.

Why Are Investors Continuing to Pile Into Emerging Market Debt?

Investors have been piling into emerging market debt

Emerging market debt (EMB) volume has been rising at a solid pace. Much of the credit is attributable to the rising issuance and attractiveness of local-currency debt (LEMB) (EMLC) being issued by emerging markets. 2016 saw a record $506 billion of local-currency emerging market bond issuances, up 32.5% from 2015, according to Bloomberg data. Also backing the above trend is the emerging market debt-to-GDP ratio, which stood at 42.7 at the turn of 2017. It was below 40 back in 2012. IMF expects the rise to expedite from here, and the ratio to cross 43.5 over the next two years.

2017 EM debt issuances expected to exceed 2016

Recovering commodity prices and refinancing requirements should buoy emerging market debt issuances in 2017, which are expected to outpace 2016. Sovereign issuances (PCY) (VWOB) form a major chunk of aggregate emerging market issuances. In 2017, Indonesia (EIDO) and Kuwait are expected to top the list of emerging market sovereign debt issuers.

Reduced risk

Sovereign CDS (credit default swap) rates are at levels last seen in 2012 (see chart above). In its simplest form, a CDS is a form of insurance against default by the issuer. So, higher the probability of default, greater the CDS spread. The cost of the CDS can be seen as the premium one pays to buy insurance. Now, CDS rates for emerging market sovereign debt have been declining through 2016. This is a good sign for emerging market countries as the perceived riskiness associated with their sovereign issues has been declining.

Within emerging market debt, local currency debt is gaining prominence as discussed in the next part of this series.