Technical Tailwinds May Lift EMFX

Performance of emerging markets local currency bonds has been negatively impacted by the U.S. dollar’s strength since mid-year, despite the higher real yields and upside growth surprises in many emerging markets. However currency returns can be volatile, and external factors can have a bigger short-term impact on an emerging markets currency (EMFX) even if relatively attractive fundamentals may provide longer term support. In addition, we believe there are technical factors that may serve as a tailwind to emerging markets local currency bonds, particularly if there is a pause or reversal of recent dollar strength.

First, flows into the asset class have been extremely subdued, and have significantly lagged other sectors of emerging markets debt. In fact, cumulative net flows over nearly a decade have been flat, and mostly negative over the period. Over the same period, the market value of emerging markets local currency debt increased by approximately 50%¹, and cumulative net inflows into U.S. dollar denominated debt have steadily increased since 2016.

Cumulative Flows into Dedicated Emerging Markets Bond Funds

Source: EPFR Global, Barclays Research.

Another factor we believe may provide technical support is the level of foreign ownership of EM sovereign bonds. The level of foreign investor participation varies in each market, and operational, regulatory and tax considerations can limit the ease at which a foreign investor can trade local bonds, in addition to a market’s relative attractiveness and liquidity. Among countries represented in the J.P. Morgan GBI-EM Global Diversified Index, the level of foreign ownership ranges from 4% to 48%, with a weighted average of approximately 21%, which has generally declined over the past six years.² That compares to approximately 33% in the U.S.³ Only 5% of government bonds in China, which has a 10% weight in the index, is owned by foreigners. The relative attractiveness versus developed markets, easing of investment restrictions, and global index inclusion are factors that we believe will lead to continued increases in this level. India, which is not currently included in global bond benchmarks but is on index watch for inclusion by J.P. Morgan with the potential to reach a 10% weight, has only 2% foreign participation in its sovereign bonds.