Local currency-denominated emerging market debt (EMD) hedged into US dollars may offer greater downside protection and lower correlation to other asset classes than its unhedged counterpart while still providing exposure to an asset class whose long-term prospects remain strong.
We believe the long-term case in favor of investing in emerging market debt remains a strong one, despite current forecasts for slow global economic growth and low commodity prices. Emerging markets are a diverse group, but nearly all have the ingredients for significant future growth; young and growing populations, abundant natural resources, expanding consumer markets and improving governance. These factors distinguish EMs from developed markets that face the future burdened by aging populations, slow growth and worsening fiscal circumstances. For strategic investors with long-term investment horizons, the benefits of exposure to EMD – both in terms of return and diversification – are not lessened by the short- and medium-term challenges currently facing emerging markets.
However, currency volatility (particularly for US dollar based investors) can pose significant risks to local currency EMD strategies as many investors have witnessed over the past three years. As the historically low currency volatility of the previous decade came to an end, some who had invested seeking fixed income type risk/return profiles instead sustained double-digit losses; the dollar strengthened on the expectation of higher US interest rates, while slowing economic growth in many emerging countries led to weaker EM currencies.