Local debt: favourable valuation

We view EM local yields as attractive at around 6% (Chart 4) and already compensating for further local currency and duration volatility. We also expect that deflation (due to lower oil prices or weak domestic demand) will create space for further policy easing by most EM central banks, and this could drive local yields lower. Differentiation will be an important performance driver for emerging local market debt in 2015 and we continue to prefer exposure to countries like India and Mexico that have stronger fundamentals, improving external sector balances and positive structural reform momentum. We still have a negative view on Peru, given its strong link with oil prices. We are also bearish on Malaysia and South Africa, in view of the low level of their real rates. In addition, the hawkish tone of their central banks could lead to rate hikes this year.

Low-yield environment supports the attractiveness of the asset class

With a yield of about 5.5%, we consider USD-denominated emerging sovereign debt an attractive fixed-income investment. We expect a spread-tightening large enough to fall below 300 bps before year-end, on the back of robust growth data and low debt/GDP ratios. Technical factors are also positive drivers. Firstly, flows should again be positive this year, keeping to the trend of H2 2014. Secondly, the lack of net new supply (i.e., new issues minus redemptions) will trigger a search for attractive risk/return issues.

As our investment philosophy is based on a bottom-up approach, we are looking for bonds with an interesting carry relative to their peers. For instance, we prefer euro issues from Croatia as the yield is more rewarding than comparable issues with similar risk profiles, such as Serbia. The euro-denominated Moroccan issue offers additional remuneration relative to the dollar issue and we expect the spread to tighten

Forex: challenging year ahead 

We expect 2015 to be a challenging year for local currencies on further US dollar strength driven by monetary policy divergence between the US and the EU and Japan.

We favour currencies with good reform momentum. In the case of the INR, the reforms in India, still ongoing, have started to bear fruit. Although the currency has firmed up in recent months, there is still room in the reversal trend for a large retracement. On the “overweight” side, we also favour the KRW. This low-beta currency is a nice-to-have in cases of risk aversion due to the solid fundamentals of South Korea (strong current account and high FX reserves). The main risk factor identified for this currency is the recent sharp depreciation of the yen as Japan is a serious economic competitor. We also like the CNY, as we consider that the depreciating trend of this PBOC-managed currency has come to an end. Similarly, it is also a low-beta currency and the country is still enjoying a large current-account surplus.

We have a negative view on commodity-linked currencies such as NGN and the PEN. We have also underweighted the ZAR: the country is facing stagflation (high inflation and weak growth data), and this could be very painful for the currency.