EMFX enters the playing field
The past five years saw a strong USD, but even during the previous 5-year window of a weaker USD, local didn’t manage to convincingly outperform. And again it produced a lower Sharpe ratio. This likely reflects that local debt time and again suffers from large depreciation episodes of markets that temporarily lose their inflation anchor (eg. Turkey). In contrast, drastic deterioration of credit fundamentals occurs less frequently, and there is more mean-reversion there as credits can improve again with IMF help, while nominal exchange rates rarely ever recover. The outperformance of external may also reflect the lower concentration of these indices and thus higher diversification. Interestingly, while local is higher-beta in terms of returns, its fund flows are stickier. Local tend to underperform external flows during periods of overall EM debt inflows as in 2017. In contrast, external flows are also quicker to leave than local ones as during the big unwind in 1H18. This is likely driven by the greater participation of retail and cross-over investors in external debt than in local debt, including greater predominance of ETFs. Among the top three local markets, we rank Russia (10y OFZ) before South
Africa (20y SAGB rateshedged), both with open FX position; sidelined in Turkey. We also like T-bills in Nigeria, Ukraine and (less so) Egypt. In external debt we like Ukraine warrants, Bahrain, Lebanon and Angola. Saudi FX forwards and Russia CDS are attractively priced hedges good to have in case of a new growth scare in 2H19.