Navigating emerging markets debt in a currency driven world

Jonathan Boyd
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We are bullish in on Hungary as a solid country with fiscal discipline, current account surplus, and a strong beneficiary of the European economic recovery. They have built up reserves, growth is picking up and it is a turnaround story as well. We like Mexico as it benefits from the recovery in the US. It’s also seen significant market friendly reforms and should continue to get a tailwind from greater US economic momentum.

At the same time, we also own more cyclical countries that are in the right place in the cycle such as Argentina, which is a turnaround story. They have a major catalyst at the end of this year with an election, which is expected to potentially usher in a more market friendly regime, bringing about a return to normalisation. Investors are also extremely well compensated for taking risks in that market with yields about 10%.

Lebanon is another slightly usual pick. It fits into a broader credit barbell strategy at play in our fund, in which we balance exposure at the two ends of the curve. At the front end of the yield curve we like exposure to higher yielding bonds that offer carry without as much duration risk, which will be important as the Fed moves towards its first rate hike. We expect limited duration bonds to have less vulnerability to Fed driven volatility and so are investing in 1 and 2 year bonds in Lebanon, which offers liquidity and an attractive risk/return profile.

Whilst we anticipate riding the front end strategy through Fed volatility, we also quite like the back end of the yield curve, where duration has sold off and looks attractive. In EMD the back end of the yield curve is extremely steep given investor concerns about duration, meaning that opportunities with 7 or 8 per cent yield are available. Certainly we remain cognisant of Fed and Treasury risk down the line, but we manage that by hedging with Treasury futures and being quite tactical and nimble with these positions.

Of course currency volatility remains a huge factor for emerging markets. We feel the bulk of the adjustments will continue to be felt in local currency markets and therefore prefer USD denominated debt. Overall the strengthening of the US dollar is general bearish for EM currencies and there is no reason to go against that trend, hence we are essentially hedged to be neutral to EM currency risk, with some important exceptions in areas like Mexico, Poland and India where we think there are interesting opportunities. However, for the most part, we think there is more pressure to come from emerging market currencies and whilst we may like local bonds we are constrained by the FX.

 

Pierre-Yves Bareau is manager of the JP Morgan Funds – Emerging Markets Strategic Bond Fund.