Last year was challenging for bond markets across the globe, with emerging market (EM) local currency bonds no exception. The index was down -11.69% ¹ for the year, although it still managed to outperform EM hard currency bonds by 609 basis points². And this was despite Russia, which had been a decent chunk of the index, effectively written off during the year. We saw some relief in the final quarter of the year when local currency EM bonds rallied by a substantial +8.45%.

Looking ahead, we think there are some good reasons to expect a much-improved performance from local currency EM bonds in 2023.

Fading inflation

In response to high inflation at the beginning of 2021, EM central banks were ahead of the curve in tightening monetary policy before their developed market (DM) counterparts. The result of this is a high policy rate differential favoring EMs that on its own suggests a fair amount of scope for inflation to come back under control. This is particularly so in the context of reduced domestic demand pressures and falling commodity prices.

The good news is that we've already seen strong evidence to suggest that the rate of price increases across EMs is now beginning to slow. Given that energy costs peaked in early 2022, we should begin to see headline inflation rates slow further in 2023 owing to favorable base effects.

Source: Bloomberg. January 2023

While there's a risk that inflation may remain elevated for some time, the general rule of thumb is that following its peak, inflation in EMs tends to come back down to earth relatively quickly. We can therefore expect to see positive real policy rates for the majority of EM countries over the next 12 months. This should mean that some EM central banks could be in a position to start cutting rates quite early (compared to DMs), which would support growth. In such an environment, the potential for returns from duration would be high.

More favorable currency outlook

Fueling the US dollar’s rally in 2022 was the fastest and most aggressive series of rate hikes by the US Federal Reserve (Fed) in 40 years. While EM currencies inevitably came under some pressure, the much-improved current account positions of many countries compared to a decade ago made them less vulnerable to capital outflows. This source of improved resilience was evident in many EM currencies falling by less against the US dollar than most DM currencies in 2022.

The greenback is still near its highest level in 20 years, but the outlook appears less supportive than before. In particular, EM countries’ economic growth differential relative to the US is projected to widen in 2023. This could be a key catalyst for EM currency outperformance. Furthermore, the carry-on EM currencies (i.e. the interest rate differential in EM countries’ favor) is now more attractive, providing another potential driver of improved EM currency performance versus the US dollar.

Yields continue to look attractive

EMs performed particularly well during the final quarter of 2022, benefiting from falling yields, substantial spread compression, and US dollar weakness. Despite the rally, valuations continue to look attractive compared to history. In 2023, we think the potential for returns over the next 12 months will be supported by elevated yields that currently stand at 6.62%³ for the JP Morgan GBI EM Index. Notwithstanding the big rally since mid-October, this is still comfortably above the long-term average.

Key risk factors

The key macro risks and potential swing factors for the global economy will be the performance of the US and Chinese economies. In terms of the latter, the outlook has certainly improved following the recent easing of zero-Covid rules. Uncertainties remain, however, including around the pace of activity normalization and the health of the beleaguered property sector. On the US side, the main risks surround the progression of the Fed’s current aggressive monetary tightening cycle and the extent of its lagged slowing impact on the US economy.

Another broader concern for the asset class is bond supply. Issuance from the region looks likely to increase significantly in 2023, partly to finance elevated energy price subsidies in many countries. On balance, our view is that current yield levels provide investors with a good level of protection for the totality of macro and other known key risks.

Importance of selectivity

While the overall outlook for the asset class is favorable, there’s still significant variation between countries, which underscores the importance of selectivity. By way of example, we currently see good value in Latin American countries, such as Colombia, Mexico and Brazil. They raised interest rates early and are now beginning to pre-announce the end of their hiking cycles. Countries in Latin America have also been major beneficiaries of rising commodity prices. Furthermore, the region has been less exposed to the conflict in Ukraine.

Putting everything together

Despite the strong rally of the latter stages of 2022, we think the overall outlook for EM local currency bonds for this year remains favorable. In particular, we think that historically still-elevated yields are indicative of attractive valuations and provide a good protective cushion for known key risk factors. Indeed, after two calendar years of total return declines, we feel the balance of probabilities points to a significantly more positive outcome for EM local currency bonds in 2023.

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