Title: Local Currency EMD: Uncovering a New Opportunity Set
Abstract: Emerging market debt portfolio manager Ward Brown joins Rob for this podcast to dig into the uniqueness of local emerging markets debt investing, the trajectory of EM economies and business cycles and potential opportunities going forward.
Rob Almeida: Hello, my name is Rob Almeida, portfolio manager and global investment strategist here at MFS and your host of The Strategist's Corner podcast. I'm always excited to do these, but I'm particularly excited about this episode because I'm joined by one of my favorite people at the organization, emerging markets debt portfolio manager and good friend of mine, Ward Brown. I really hope you enjoyed this episode where Ward talks about local emerging market debt bonds, hard currency emerging market debt bonds and just his general view on risk assets in the world today. Thanks for listening.
Rob Almeida: Ward, thanks for joining.
Ward Brown: Hey, Rob. Thanks. Good to be here.
Rob Almeida: How are you?
Ward Brown: I'm good. How are you doing?
Rob Almeida: I'm pretty good.
Ward Brown: All right.
Rob Almeida: Interesting world we're living in right now.
Ward Brown: Yeah. Yes, it certainly is.
Rob Almeida: You recently put out a white paper, a really good piece I'd encourage everyone to read on the opportunity set that's happening in local emerging market debt. But before we get into that, maybe just level set for me, what are the structural differences between dollar-denominated debt and local emerging market debt? How do you differentiate those two worlds?
Ward Brown: Well, the biggest differentiator is that the local debt is in local currency, so if you're lending in local currency to the Brazilian government, you're lending in Brazilian reais as opposed to lending in US dollars. That means a couple of things drive that local debt that are different than the US dollar debt.
Rob Almeida: Okay.
Ward Brown: The biggest thing is inflation. So, the local currency debt behaves a little bit like US treasuries do. When the fed hikes rates, treasury rates go up, treasury bonds fall. That's true of the local currency debt in all emerging markets. In Brazil, they've been hiking interest rates this last year and those interest rates have gone higher and higher, the prices of the bonds have fallen. That's the main thing, that inflation and local business cycle doesn't affect the dollar debt because the dollar debt's in dollars, it doesn't really matter what local inflation is. What affects the dollar debt is mainly the risk of the sovereign defaulting, and that, of course, can affect the local debt as well. Local is like dollar debt plus a business cycle inflation component.
Rob Almeida: Okay. When you're looking at the country in itself, and you've been working in emerging market debt for a long time, and I maybe left that part out in the intro. I should have covered it. Seven years at the IMF, almost 20 years, so you've been working in this space, financing emerging market countries for a long, long, long time. At a high level, obviously you mentioned you're looking at inflation, you're looking at the business cycle, but as a lender or as someone who's studying the financials and the capability of it, what are some of those key performance indicators that are important to you?
Ward Brown: Well, you want a sound macroeconomic framework. That's where you're looking for a country to run, and that means that the fiscal deficit is on a sustainable path, debt is stable or declining, and when that's the case, usually the inflation credibility is high. That is, inflation's well anchored. People believe the country's inflation target. That's the ideal. Not that many emerging markets have that, but we look for countries that are headed in that direction.
Rob Almeida: Do the developed markets have that?
Ward Brown: Well, that's another debate, I'm sure you've had that debate with Eric many times. But they have it a lot more. One thing coming from emerging markets, you really understand a little bit better I think what it means to not have a strong inflation anchor. That mainly comes from not having a good macro framework and a good macro framework, the centerpiece of that is good fiscal.
Rob Almeida: Maybe taking us back to when you started a long time ago, net net, has that framework improved on the margin? If you'll take the asset class . . .
Ward Brown: Oh yeah, oh yeah. Big time. Way back in the time of crises when we had several emerging market crises . . .
Rob Almeida: Late '90s, you mean?
Ward Brown: Late '90s, early 2000s, they had a much different macro framework and it was based around fixed exchange rates, so pegged exchange rates.
Rob Almeida: Sure, all right.
Ward Brown: Those were unsustainable and that's partially why there were these crises. They got rid of the pegged exchange rates and introduced inflation targets and became much more credible in their fiscal policies so that the inflation targets also became credible.
Rob Almeida: Yeah.
Ward Brown: What we saw for the 10 years prior to the pandemic was a steady decline in actual inflation rates in emerging markets, which a lot of that is attributed to better and more sound macro frameworks.
Rob Almeida: Which naturally explains why the asset class has done so well for a long period of time. Just that overall improvement, so you've got an improvement in the macro framework, an improvement in the inflation dynamic, and lower risk premium, higher return for investors.
Ward Brown: Right, right.
Rob Almeida: Maybe fast forward to today and what you and Benoit were hiding in your piece is that there's, you called it four stages to a cycle. Maybe walk us through a little bit of that.
Ward Brown: Yeah, sure. You painted a nice backdrop because what you did was describe the structural trend that's going on.
Rob Almeida: Well, thank you.
Ward Brown: That was really good.
Rob Almeida: Oh, look at that.
Ward Brown: Because that's a good backdrop for this because on top of that structural trend is the business cycle.
Rob Almeida: Okay.
Ward Brown: Just like any business cycle, if inflation's too high, the central bank needs to raise interest rates. If the economy goes into recession, then the central bank needs to cut interest rates, and that's what our paper talks about, the business cycle in emerging markets. It's linked to the US business cycle because when the Fed changes interest rates, that has an impact on emerging markets. If the Fed raises rates and an emerging market doesn't raise rates, then the currency's probably going to depreciate. If the currency depreciates. Then you can have some problems in the country, sometimes you have inflation go up. It sort of forces a central bank to hike.
A key part of the business cycle for emerging markets is the US business cycle and usually the very beginning stage of the US business cycle, we started at this stage in our paper, is when interest rates are low, the economy is recovering in the US and the Fed begins hiking. That's the beginning. As the hikes go on, you get into the second stage where, okay, they started at a level, just think back in 2021, really accommodative. The first couple hikes, that's okay because they're still accommodative, but once they start hiking further, it starts to be a little more restrictive and the impact starts to be felt on emerging markets, their currencies depreciate, and those central banks then start hiking interest rates as well.
Rob Almeida: That's stage two.
Ward Brown: That's stage two.
Rob Almeida: Okay.
Ward Brown: Stage one is the Fed starts; stage two is EM central banks start to hike rates. Stage three is when the Fed pauses and at that stage there are two possible outcomes. One is that you have a soft landing where inflation declines, but you don't go into recession, and because inflation declines, then the Fed can start cutting rates.
Rob Almeida: Right.
Ward Brown: Fed cutting rates is stage four. Then the other outcome of stage four is a hard landing. We start to go into recession and the Fed cuts rates more aggressively. In both of those cases, EM central banks will also be able to cut rates. The period that in these cycles that is most beneficial for local currency debt is once the rates start cutting, that's really a perfect entry point usually and once the Fed has done enough to stabilize risk appetite, then we start to see the move of capital flowing into emerging markets and you get some dollar weakness, that is emerging market currency start to appreciate, and that helps support the disinflation and then central banks there can cut some more and then growth starts coming and capital starts flowing.
Rob Almeida: So, you get a positive feedback loop if you go in.
Ward Brown: That's the fourth stage.
Rob Almeida: Given you mentioned the Fed and its importance relative to stage three and transitioning it to stage four just internally, and you and I have been on the same page or at least been consistent in our view on this, but share with the audience, risk assets, high yield bonds, high grade bonds, equities, et cetera, are signaling one thing. I would argue it's more complacency on behalf of the risk markets relative to what you're seeing in the real economy, the shape of sovereign bond yield curves. What's your view on, I guess, where we are at economically, globally and what that means for the Fed and central banks?
Ward Brown: Well, I think in terms of the macro, the central banks, obviously, their priority is to bring inflation down. If that means that a recession has to happen, they're prepared to accept that as long as that'll guarantee inflation comes down. I think that's probably a high probability that we have recession because of the communication that they've given us, they're looking at very lagging indicators like core inflation to gauge how to adjust policy. Those indicators lag a lot, so that means they're unlikely to cut before unemployment starts rising. Once unemployment starts rising, that's really the beginning of a recession and it's hard for that to just rise a little bit. That usually rises a lot, at least that's a historical experience. I think the macro setup is got a pretty high probability of recession.
The question on the investing side is what assets are compensating you for that risk of recession? Because we should say you can't roll out a soft landing. You and I know, we debate this a lot with our colleagues, how could a soft landing come about? It's less clear to us that things look good for a soft landing, but it could happen. If it were to happen, risk assets would do quite well. When I look at emerging market debt, only a part of the asset class is pricing in a hard landing, most of the asset classes is not pricing that in, but it also is not pricing completely a soft landing, so there is room for our asset class and I think in others to rally somewhat in a soft landing environment. But they don't compensate for the hard landing, and when we look at it, we think that on balance, it pays to be a little cautious in a lot of assets, especially just in risk allocation because not that many assets compensate for the hard landing probability, which as I said, I think is fairly high.
Rob Almeida: It just seems like the investment community today has been programmed or conditioned ever since Alan Greenspan to think that the central banker cares about risk asset but to your point, no, it's inflation. They've got . . .
Ward Brown: You're talking about the Fed put?
Rob Almeida: Yeah, right.
Ward Brown: That's not there.
Rob Almeida: It's not there.
Ward Brown: No, it's absolutely not there because . . .
Rob Almeida: Or if it's there, the delta is 0.0000 something.
Ward Brown: Right, exactly. It's so out of the money and that's because they need to bring inflation down and we haven't been in this situation for 15, 20 years, so that's why the put has always been there and come out pretty quickly because if inflation's below target, you don't need the economy to go into a recession. But if inflation's above target, you might need it to happen and that's where we are now. That's why, yeah, the put is probably not going to be exercised in this cycle.
Rob Almeida: Let's come back to so in between stages three and four, but you've advocated — and you advocate this in your piece — just thinking about emerging market debt, the opportunity set, why should investors be thinking about it now?
Ward Brown: Well, because we've got this — so I gave the standard cycle, the standard stages. This cycle was a little bit different and one of the big differences, remember stage one, the Fed hike, stage two is central banks hike, EM central banks hike. That got reversed this time. EM central banks got out way ahead of the Fed.
Rob Almeida: That's interesting.
Ward Brown: It's quite remarkable. It meant that usually what we see when the Fed hikes is significant weakness in EM currencies. We didn't really see that last year. Yes, the dollar was very strong last year, but it was strong against the euro and other developed countries. EM hung in with all of those countries, in fact outperformed the euro last year. That is because EM central banks got way out ahead and started hiking much before the Fed and the ECB did. That puts them in a much different position, so if we go into this hard landing, first of all, I would say the scope for cuts by EM central banks is really large. In Brazil, we're talking about a 13.5% policy rate, inflation's under 4% right now.
Rob Almeida: They tightened earlier and more.
Ward Brown: Yes. They tightened earlier and more. That puts a huge cushion in there. In the beginning of the fourth stage, if we go into a hard landing, you have risk aversion and that typically means people want to go back to the dollar and that can be problematic for central banks in emerging markets, but because they've hiked so much already, they've built in a big risk cushion for that spike in risk aversion that can happen if we go into recession. That should help stabilize these currencies. Often what will happen is that they're behind the Fed, we have a risk off episode, and they have to hike even more. That's the usual playbook, but because they started out before the Fed, that playbook is — I don't think going to work out the same way this time.
Rob Almeida: Interesting.
Ward Brown: They've already done those extra hikes.
Rob Almeida: Right, right.
Ward Brown: They're in a position that's really strong in terms of the room they have to cut rates and the real green light they'll get is when the Fed pivots to a dovish stance and now, how early is the Fed going to pivot? I don't think it's going to be ahead of recession, that's what they should do if we were going to avoid a recession. I doubt it, but once they start pivoting, it's going to really provide a lot of space for EM central banks to cut rates and it's going to start to usher in some dollar weakness. That's really when returns can be quite strong in EM local currency.
Rob Almeida: Before I let you go, as you were talking through that, and you mentioned Brazil — and we can leave them out, you don't have to offer an example — but explain or talk about the importance of fundamental homework, security selection within that framework because obviously we're talking about a big landscape, a lot of countries, different funding needs, different revenue sources, different business cycles, and it's of course all tied to the Fed like you described, but there's so much idiosyncratic risk is what I'm trying to drive at.
Ward Brown: There is, there is, and we're talking at a general level here, so I'm generalizing this. What I've said is not true of every country in EM and country selection is key. It is the key component to successfully investing in emerging market debt.
The most important thing is to be aware of countries that have fragile sovereign risk profiles.
Rob Almeida: Okay.
Ward Brown: Those countries could cut rates too, but if they run into a sovereign debt problem, that rate cutting is going to be put on hold and it's going to go the other way. We've seen that many times, so you have to be wary of those countries that are vulnerable. At the same time, you also need to use good country selection to find the spots in the asset class that have the most upside. We're not overweight duration everywhere in the asset class. There's spots where there's really, really great opportunities and we think that's going to dominate the index as well, but there's areas like much of Asia where there aren't that many opportunities like I've been describing for rate cutting cycles and we're very cautious there.
Rob Almeida: That makes sense. Ward, thank you so much for being here.
Ward Brown: Yeah, great, Rob, it's always great to talk to you.
Rob Almeida: Same here.
Ward Brown: Thank you.
We're doing something a little bit different in today's podcast. Rob asked me to do the wrap up. Today we talked about emerging market debt and specifically we talked about emerging market local currency debt. The local currency debt goes through typical business cycles. It's gone through four of them over the last 20 years, and right now we're approaching one of the stages of the cycles where returns can be quite favorable in emerging market local currency debt, so we think investors should keep their eyes open for these opportunities. Thank you very much for listening and for more, please check out The Strategist Corner podcast on mfs.com or wherever you get your podcasts.
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