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TCW is a leading global asset management firm with over 50 years of investment experience and a broad range of products across fixed income, equities, emerging markets, and alternative investments. In each episode of TCW Investment Perspectives, professionals from the firm share their insights on global trends and events impacting markets and the investment landscape.
Welcome to the TCW Investment Perspectives podcast.
I'm Anisha Goodley, head of the portfolio
specialist team for TCW's Emerging Markets Group.
I'm here today with Jay Lee, our Emerging Markets Local Currency Strategist.
Jay works very closely with our portfolio managers and
research analysts on EM rates and currency positioning.
Jay joined us in 2015 after 14 years of experience as a rates and FX trader.
Jay, thanks for joining us today.
Thanks very much.
Happy to be here.
There's a lot to talk about.
To set the stage, EM local currency debt has returned over 9% this
year, outperforming EM hard currency debt by around 400 basis points.
Jay, what do you think about the balance of the year?
What are the main drivers going to be for EM local currency
returns and what do those returns potentially look like?
Sure, that's a very good question.
It's been a very strong year for the EM local currency
index, but we think there's a lot more opportunities ahead.
Two big things.
We haven't really seen a big decline in the broad dollar.
It's been a pretty gradual decline path.
And if you think about where we can go from here, there's a lot more room for
the dollar to decline because we have central banks in the developed markets.
They're pretty much at the end of their hiking cycle.
Fed expectations are pretty low right now.
We may or may not get one more hike.
ECB, again, similarly may or may not get one more hike by the end of the year.
And there's more and more evidence of US
inflation and growth slowing down at the margin.
And that's really supportive of another phase lower
in the dollar as US exceptionalism starts to wane.
And that's really a really powerful driver of FX
returns for the local currency index going forward.
On top of that, we still have very high real rates.
We have inflation dynamics that are even more supportive
for emerging market currencies going forward.
And that allows room for us to really see the carry portion of the portfolio
really do well in a relatively benign FX environment, but one that has
potential to be more than just benign for the FX and start to see material
FX returns of, let's say, maybe 3 to 5 percent over the next few months.
So that really is supportive of double-digit annualized
return outlook for the index for the remainder of the year.
So we can still see 5 to 8 percent returns with about 2.5 percent
from carry, another 3 to maybe 5 percent really on the FX side.
And duration returns, while they've been the big driver in the first half
of the year, we think they'll be mostly flattish as we've mostly priced
in a lot of the rate cuts that are about to happen from emerging markets.
So Jay, that's a really interesting point that you just made.
So when you think about just the drivers of return for the first
half, it was, as you said, it was really more rates-driven.
But I want to actually ask you a question about the FX portion because you
made the point about maybe we're unwinding some of this US exceptionalism, but
yes, EM central banks hiked rates well in advance of the Fed, but now that
they're starting to cut rates, wouldn't that put pressure on EM FX returns?
Walk us through that a bit.
Sure.
Historically, actually, emerging market currencies don't react as badly
as you would think to rate cuts as compared to developed markets.
One of the big things that happens in emerging markets is they're usually hiking
rates as the currency is depreciating because there's negative impact from
inflation, asset volatility, current accounts might be declining, etc.
Usually when emerging markets are cutting rates, that tends to be
a supportive environment for the currency and the growth outlook.
You're talking about high real rates, you're talking about declining asset
volatility, and potential for improved investor flows across products.
So when you're cutting rates, that improves your growth outlook, people tend to
be more supportive of the domestic equity outlook as well as the bond outlook.
And that's really something that we think differentiates emerging markets
in a meaningful way from developed markets in terms of how do you trade
FX going forward as we're shifting regimes from
a hiking cycle to a meaningful cutting cycle.
So we think at least the first half to two-thirds of the cutting cycle
in a lot of these markets will still be supportive for emerging markets.
Now that doesn't mean that FX is going to create massive
returns like we've seen in some of the markets like Colombia,
Hungary, Brazil, Mexico in the first half of the year.
Give us some context.
What do those returns look like for this year?
So if you look at total returns, Colombia, Hungary, Brazil, Mexico, we're
talking double-digit returns that we've already seen just on the currency
side, not factoring in the pretty very attractive double-digit carry.
What we think going forward is, yes, emerging market currencies will start to
slow down the pace of appreciation among the high yielders as central banks cut.
That will lead to more consolidation and stability, which will
still allow investors to benefit from the very attractive
real rates and very attractive nominal carry profile.
What we think happens going forward is the lower yielders that have
lagged the market more broadly, in particular in Asia, as US rates
have risen, will actually start to benefit because now we're
at the end of the hiking cycle in the US and in Europe.
And that now really negates the interest rate differential
that was going the other way for those markets.
And we could start to see those Asian markets where valuations are really
attractive start to catch up as then now the market shifts to growth
differential being a bigger driver of currencies going forward.
That's a really interesting point about potentially the shift
away from Latin America and then just potential shift into Asia.
Jay, on that note, I think what's interesting what you were saying
is, you know, some of these top performers from this year, there may
be a shift potentially way out of Latin America into Asia, right?
So why don't, for the audience, why don't you just give
us an example of one market that you're excited about?
One of the markets that we think has really attractive
risk-adjusted return potential is in Thailand.
You have a country that has a very strong outlook for the current account.
We expect that to go back into a material
surplus off the back of tourism recovery.
We think that it has positive tail risks associated with a recovery in China.
If we start to see the government react with meaningful
growth stimulus, that should then filter into the Thailand
outlook, both on tourism but also on exports, etc.
And then we still have this unknown around Japan and yield curve control.
As we start to see normalization in Japanese interest rate
policy, we expect the dollar to weaken versus the yen.
One of the currencies with the highest beta and correlation
to Japan is actually Thailand, and there are a number of
reasons for that associated with trade relationships.
But we think that even without those extra catalysts, Thailand has its
own domestic drivers of appreciation from fairly attractive levels.
Once you have developed market rates start to stabilize as we're
end of the hiking cycle there, this should allow the currency
to react positively to those domestic and regional catalysts.
You actually touched on two things I wanted to ask you about next.
So that was Chinese growth and then also just
the impact of the yield curve policy in Japan.
So I think that was a really great example to demonstrate those two factors.
Let me ask you one other question though that tends to come up a lot.
You know, how do you broadly manage FX volatility?
I think it's important to think about FX volatility.
The difference between volatility that's bad and volatility that's good.
We obviously do like volatility when it means higher returns for
investors, especially in markets where you have very strong fundamentals.
You want the market to be volatile because you get positive reaction.
What we're really focused on is managing the downside volatility, and the way
we do that is we think about what are the drivers of that downside volatility.
They tend to be macro shocks, whether that comes from
emerging markets or it comes from developed markets.
And so we're opportunistically adding portfolio hedges, and that's really
something that allows us to weather the storm when we believe that the
underlying fundamentals of the domestic story are very strong and long-lasting.
Right, because that 9% this year has not been a straight line up.
No, it hasn't.
I mean, we've had markets deal with the uncertainty around US
debt ceiling, around the small and medium-sized banks, and
how that would then play out to the growth outlook globally.
And we've had disappointment around China's exit
from a very, very conservative COVID policy.
So now as we've gotten through this, we've been able to hold on
to those exposures that we think have meaningful upside return.
We've been able to maintain exposure to those core markets
that we think have strong domestic fundamentals by weathering
the storm in those situations through portfolio hedges.
The other thing we've been doing is actively looking at the
exposures within regions and focusing on the technicals
and fundamentals of the relative value within the region.
So we may maintain a broad exposure throughout the macro
cycle, but within that we're really looking for the
best risk/reward expression at any given point in time.
And that's allowed us to, again, better navigate what has been a challenging
market in terms of volatility, but one that's yielded very attractive
returns for investors who've been able to weather the storm.
Right, it's provided some opportunity as well because there's
been pretty significant dispersion as you touched on earlier.
Yes, in fact if you look at the returns for the index,
it's very much been a case of haves and have-nots.
The Latin American CE region, they've all experienced double-digit returns.
By comparison, Asia has been flat to marginally down.
And smaller markets like Egypt and Turkey where you've seen extremely
negative returns off the back of very disappointing domestic fundamentals.
Thanks Jay.
So last question maybe.
Last question for me right now is, you demonstrated this case of potentially
slowing US growth, some Chinese stimulus, and what you've basically seen
the last few months is surprises on the upside for
the US, downside for China, that may be shifting.
What do you think is kind of the sweet spot for EM Local?
We're starting to build a bigger overweight bias to Asia effects from here.
As we mentioned, there is a lot of upside because the market has really gotten
very bearish on the China growth outlook and we think most of that's priced in.
So if you do get a positive reaction function from the government to stimulate
aggregate demand in a meaningful way, we think Asia effects can really
catch up, especially in an environment as we mentioned earlier where
there isn't a broad move higher in core developed market rates.
The second thing I would say is we're really going to be a lot
more dynamic about where we want to have duration exposure.
We're focused on markets that with low correlation to US rates
volatility and much more stronger reaction to domestic catalysts.
And the last thing I would say is we're still in an environment where
interest rates matter, but matter more for the carry and going forward what
drives effects returns is going to be growth differential and we're in
an environment where we still expect EM growth to meaningfully be
higher than developed market growth by at least a factor of 2.4x.
Right, the widest in a decade effectively, right?
Exactly, and one that has upside surprise potential from here, whether that
be from the US slowing down a little bit faster off the back of the lag
effects from these higher rates that we're experiencing
and/or China recovering in a more meaningful way.
And we also have Europe in a much better situation than we were a year ago.
If you just think about the energy shocks that they
experience, we're not going to experience that this time
going forward because they're just better positioned.
Gas storage levels are at 88% right now, so they're really well prepared for the
winter as compared to historical averages and especially compared to last year.
So we think there's much more downside to growth in developed markets
and much more upside potential to growth in CE and Asia especially.
And if you think just stepping back more broadly, if you look at
the last decade we know local currency has been effectively one
of the worst sharp ratio trades out there, right, in the market.
Yeah.
It sounds like you think that's shifting.
If you look more broadly over the next decade, what do you think?
I think it's very important to think about what's driven that poor sharp
ratio and poor return outlook and it really has been currency volatility.
And as we talked about earlier, there is good volatility and there's bad
volatility and we've experienced a lot of bad volatility up till now.
But in an environment where the dollar is structurally overvalued and we
can look into whether it's versus developed markets or emerging markets,
there is the potential for a broader trend lower in the dollar.
And now we're in an environment where we can actually have
currency volatility be additive to returns going forward.
And that's an environment that's also supportive
for the bonds within these emerging markets.
As currency volatility declines, as currencies appreciate, that
generally leads to better outlook for stability in local bonds
and also the lower risk premia in local bond markets as well.
Great.
Thank you so much, Jason.
Let me just try to recap what you discussed.
I mean, it seems like we do anticipate that the
broad dollar is likely to continue to decline.
You have developed market central banks finishing their hiking cycles.
You're seeing real data around slowing inflation and slowing growth.
And so maybe that US exceptionalism starts to unwind.
And then the growth expectations in EM are improving.
So I think it's what your point, you know, it was really
interesting in terms of EM is not necessarily DM.
The way DM rates and DMFX may trade, that's not
necessarily the way EM rates and EMFX may trade.
Although there may be, you know, of course there are correlations.
But your point about how we're approaching these rate cutting
cycles, it may not be as negative for EMFX as what you would think.
That's correct.
And I think we're in an environment where you really have a chance
to have differentiated returns for emerging markets going forward.
Great.
Well, Jay, thank you so much for spending time with us today.
Thank you very much.
Thank you for joining us today on TCW Investment Insights.
For more insights from TCW, please visit tcw.com/insights.
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