This is a sponsored article from State Street Global Advisors.

Kheng-Siang Ng Asia Pacific Head of Fixed Income State Street Global Advisors

Forecasts in early 2018 of a return of volatility after two years of near-somnolent developed markets seem to prove more prescient with every passing month, with significant implications for emerging market assets.

As we saw, yields in core markets finally began taking off early in the year. In the US, wage and employment growth as well as expectations of Fed rate hikes propelled 10-year Treasuries to a multi-year high. The rate increases duly came and bolstered yields further, while President Trump’s trade hostilities and the subsequent Chinese responses drove money into traditional safe havens, with 10-year Treasury yields hovering around 3%. Despite strong signs that the US is on an upswing, anxieties over geopolitics and trade continue to simmer and infect Asian markets.

After such a prolonged period of stagnation during which global capital had poured into Asian assets in search of yield, local debt was inevitably seen as vulnerable in this environment.

Outflows from Asian debt began in April and have not abated since. Spreads on emerging market bonds are hovering near a two-year high over Treasuries, propelled by trade fears, a stronger dollar and tighter liquidity. Rising oil prices are threatening to swell the current account deficits of major importers like Indonesia, India and the Philippines; Asian currencies have been in decline – notably the Indonesian rupiah, Philippines peso and South Korean won; and the region’s stock markets hit a collective nine-year low in early July as the first round of US tariffs loomed.

Asian debt continues to hold up well
It’s not all doom and gloom for government debt, however. For one thing, the global economy is doing quite well, and the flight from emerging markets has not been as bad as portrayed.

Asian debt holdings are still equal to the long-term average, which may indicate a resilient demand, and though local currency bonds have lost value, they are still higher than they were a year ago.

The focus on the potential damage of a US-led trade war has been fuelling volatility, but the prospect of Asian markets is becoming less dependent on the US, which may buoy sentiment in the long term. Trade growth in Asia is the fastest in the world, and a trade war could accelerate a shift in trade corridors for the benefit of some Asian economies.

Indeed, Chinese government debt has been a beneficiary of the trade conflict, even as stock markets and the currency tumbled. In June, foreigners bought Chinese sovereign bonds at the fastest rate in almost two years, and the yield on the 10-year note reached a 14-month low of 3.47% in early July. Any escalation of the trade war could lure risk-averse foreign capital into bonds at an even faster rate, and with the Chinese government committed to supporting the currency, the danger of the yuan tumbling further is relatively limited.

Where to from here?
After a stellar run in 2017, Asian local currency debt is facing several headwinds as many of the conditions that enabled that run have started to weaken.

Nevertheless, while investors will need to exercise more cautions, the outlook remains positive. Yields are still in a reasonable range, with credit spreads having moved up as much as 60 bps so far this year. EM local currency debt still provides investors with a healthy spread over US Treasuries and with a lower US interest rate risk than hard currency bonds.

Many EMs now issue debt in their local currency as opposed to hard currency, much of which is held by domestic investors, rendering it less subject to the vagaries of international flows and less sensitive to dollar moves.

With weak capital flows and political uncertainty in Europe unlikely to subside anytime soon, the dollar is likely to continue strengthening over the course of this year. Despite short-term macro risks such as dollar strength and the potential for further trade turmoil, we prefer local currency over hard currency EM debt. According to State Street’s measures of fair value, Asian currencies are around 5-6% undervalued against the dollar, representing an opportunity in local debt. Since much Asian debt is held by local investors, this makes it less vulnerable to international flows, and with account balances generally healthier than before the global financial crisis, the risk of contagion from troubles in Turkey or Brazil is lower than before.

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This is a sponsored article from State Street Global Advisors.