Kames’ chart chat: Two graphs showing why EM debt is still attractive amid inflation decline

Local currency emerging market debt continues to be one of the most attractive asset classes available to investors in the current environment thanks to dwindling inflation across many developing countries, according to Kames Capital’s multi-asset team.
While all major emerging market asset classes have performed strongly this year due to improving economic and trade growth, and US dollar weakness, the real yields still on offer from local currency emerging market debt remain attractive, especially compared to developed market government debt.
Colin Dryburgh, investment manager with Kames Capital’s multi-asset investing team, working across funds including the £318m Kames Diversified Growth fund, says the decline in inflation in EMs is countering the reduction in yields seen across emerging market debt.
“One less talked about but important issue for emerging economies has been inflation – or rather the recent lack of it,” he says.
“In all likelihood the principal driver of this has been lower commodity prices but it is possible that emerging economies are increasingly participating in the broader global disinflationary trend.”
While developed market bonds are also seeing lower inflation, Dryburgh says record low yields on many bonds mean investors sticking with traditional government bonds face the prospect of negative returns.
“Yields in most fixed income categories are at or close to all-time lows,” he says.
“However, the real yield – calculated as nominal yield less current level of inflation – in many local currency government bonds is currently at or above historic averages.”
The chart below shows the average real yield, using the above mentioned measure, for a selection of developed and emerging government bond markets.

Source: Bloomberg as at 29 September 2017
*       Defined as 10 year government bond yield less current headline CPI.
**     Average of Indonesia, Mexico, Poland, South Africa, Brazil, Thailand, Turkey, Columbia, Russia and Malaysia.
***   Average of US, UK, Germany and Japan.
The risk for emerging market debt denominated in local currency is dollar strength. A resurgent US dollar would negatively impact the sector, which is higher risk than hard currency emerging market debt.
Nonetheless, Dryburgh says given current valuations for currencies, the US dollar continues to look fully valued, especially when viewed against its average value over the past ten years.
“The good news is that, despite performing well year-to-date, many emerging market currencies do still appear to be attractively valued relative to history, while the US dollar is currently expensive,” he says.

Source: Bloomberg as at 29 September 2017
Within the fixed income portion of the Diversified Growth fund, top holdings include the iShares JPMorgan EM local government debt ETF, as well as bonds from Mexico and South Africa.
“This combination of attractive currency valuations for many regions, coupled with high real interest rates relative to developed markets, makes local currency EMD an attractive asset class for multi-asset funds,” Dryburgh adds.