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Emerging Market Debt: Reconsidering A Beaten-Up Asset Class

History has a way of repeating itself in financial markets. Previous environments of rising U.S. interest rates and a stronger dollar have plagued emerging markets assets, including bonds.

It's occurring again this year as exchange traded funds holding both dollar-denominated and local currency-denominated emerging markets debt are flailing. The VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (NYSE: EMLC), one of the largest ETFs holding developing world debt issued in local currencies, is down more than 6 percent this year.

What Happened

A strong dollar hampers emerging markets debt issuers on multiple fronts. There is the obvious effect of the dollar strengthening against local currencies. Commodities are also part of the equation. Several large developing economies, including Brazil and Mexico, are major commodities exporters and producers. A strong dollar usually means weaker commodities prices. Twenty percent of EMLC's currency exposure is the Brazilian real and the Mexican peso.

“As emerging markets local debt lost more than 8 percent since the beginning of April and moved into negative territory for the year, there were some powerful reminders of the sources of volatility that can appear among the geographically, economically and politically diverse landscape of emerging markets," VanEck said in a recent note.

Why It's Important

At the start of this year, many market observers expected Mexico would be the only emerging market to raise interest rates. Mexico has raised rates, but other developing economies have, perhaps surprisingly, joined the party. That includes Argentina and Turkey.

“Second, additional risk has also been priced into most of the better economic and political performers,” said VanEck. “Ironically, one of the worst-performing markets, Argentina, has been pursuing fiscal reforms and has a central bank that has reacted prudently and independently to negative flows.”

Argentina's benchmark borrowing rate is now 40 percent while Turkey's is 8 percent. Those countries combine for 7.7 percent of EMLC's weight.

What's Next

Political risk is potentially on the horizon for emerging markets assets. Next month, Turkey holds national elections followed by Mexico in early July and Brazil in early October.

“In addition, although rate increases by the U.S. Federal Reserve continue to be gradual and well-telegraphed, any signals that elevate the probability of three or more additional hikes over the remainder of the year will likely result in more pain for emerging markets currencies,” according to VanEck.

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