Emerging market local bonds returned a stellar 12.7% in 2023 in US dollar terms but lost 3.7% in the first half of 2024 amid a strong dollar, concerns about fiscal discipline in Brazil and the prospect of post-election institutional deterioration in Mexico.
The asset class recovered strongly between July and September, delivering a 9% return in a single quarter despite market turbulence and the unwinding of yen-funded carry trades. While Brazil and Mexico’s issues persist, investors are shifting their focus to US events that are moving the dollar and potentially boosting local assets in emerging markets.
The US presidential race appears very tight. Kamala Harris is slightly ahead in the national polls but Donald Trump could still win, given that the results for many swing states will be a toss up, according to opinion polls.
The dollar would likely strengthen under a Trump victory and weaken otherwise due to two economic reasons: taxes and tariffs. Trump has promised to extend the corporate tax cuts he introduced during his first presidency, which increased competitiveness and attracted capital flows from corporations and resulted in a stronger dollar. Harris, on the other hand, has promised that the wealthiest Americans and largest corporations will pay their fair share.
If elected again, Trump would impose more tariffs on China and potentially on the rest of the world. A country facing higher tariffs will see its currency weakened by market forces to compensate for lower competitiveness. This was evident in the Chinese yuan during the 2018 trade wars.
We expect the US-China rivalry to continue regardless of the outcome of the election, though it is likely to be less disruptive under Harris.
Taxes and tariffs point towards a stronger dollar if Trump wins. If Harris wins, the sentiment towards emerging markets should improve amid prospects of a weaker dollar.
Can we stay in the middle of the so-called US ‘dollar smile’? Currencies strengthen when their economies are doing well and vice versa, but the US dollar also strengthens in times of crisis on safe haven flows due to its reserve currency status.
The dollar remained strong after the Covid pandemic on the back of strong US growth. A hard landing would imply dollar strength on safe haven flows.
But in our soft-landing baseline, we could move towards the middle of the smile: weaker US growth and a weaker dollar. Should this occur, it would be a game changer for sentiment towards emerging market local currency debt and we would expect double-digit returns to ensue.
Real rates remain high in emerging markets amid orderly disinflation; many major emerging market central banks hiked rates faster and more aggressively than their developed market counterparts in 2021 and 2022 after the pandemic and cut rates earlier starting in 2023. These rate cuts contributed towards the double-digit returns achieved in 2023. Many emerging market central banks paused through 2024, while others continued to cut but more cautiously, waiting for the US Federal Reserve.
Local currency bonds are also set to benefit from the easing monetary cycles overseen by most developed market central banks, which includes the Fed after September’s 50-basis points cut. The effect of these cycles is indirect, but still powerful.
Emerging market central banks have already been cutting rates since last year but some of them have paused or taken a more cautious approach in 2024. Now that the Fed has started cutting rates, several of them have resumed and may accelerate their own rate cutting cycle.
Indonesia’s central bank cut rates on the same day as the Fed, while South Africa, China, Hungary, Czechia, Mexico, Costa Rica, Dominican Republic among others followed suit soon after. Only Brazil bucked the trend with a 25bps hike.
This global easing cycle is likely to boost emerging market local currency bond prices and lower domestic borrowing costs for sovereigns and corporates.
Active investors are likely to find plenty of idiosyncratic opportunities since cycles will be much less synchronized, as not all countries have been equally successful in their fight against inflation.
Carlos de Sousa is an emerging market strategist at Vontobel. The views expressed above should not be taken as investment advice.