Emerging Markets Sovereign Bonds Short-Term Outlook Bearish

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 |  Includes: ELD
by: Mardo Iknadiossian

With all the financial turmoil surrounding Europe and America, it may be time to look at some emerging market debt as an investment. An interesting ETF to look at is the WisdomTree Emerging Markets Local Debt Fund (NYSEARCA:ELD). It seeks returns of both capital and income appreciation by investing in local debt denominated in the currencies of emerging market countries. Here is some basic information about the ETF:

Here is a breakdown of the ETF’s portfolio allocation by country:

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(Click to enlarge)

The majority of the holdings are in Asia and Latin America where exporting countries have amassed large foreign exchange reserves and have low debt-to-GDP ratios relative to developed nations. Below is a Table with some economic statistics.

Country

GDP (Billions)

GDP growth rate

Debt-to-GDP ratio

Credit Rating

Brazil

$2,090.00

3.16%

66%

BBB

Indonesia

$706.70

6.50%

26.90%

BB+

Mexico

$1,039.00

3.30%

42.70%

BBB

Malaysia

$238.00

5.80%

54.20%

A-

Turkey

$741.90

8.80%

41.70%

BBB-

Thailand

$318.90

2.00%

44.10%

BBB+

South Korea

$1,007.00

3.40%

30.86%

A

South Africa

$357.30

3.00%

35.70%

BBB+

Russia

$1,465.00

4.80%

9.00%

BBB

Poland

$468.50

4.30%

55.00%

A-

Peru

$152.80

6.70%

24.30%

BBB

China

$5,878.00

9.10%

17.70%

AA-

Philippines

$188.70

3.40%

47.30%

BB

Chile

$203.30

4.80%

8.80%

A+

Colombia

$285.50

5.20%

36.50%

BBB-

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As the table shows, the countries have high growth rates, relatively low debt-to-GDP ratios and good credit ratings; in fact majority of the countries have ratings of investment grade (BBB) or higher by S&P. The risk in emerging market debt is not a risk of default; it’s high inflation and weak currency exchange rates.

Short-Term Outlook

The crisis in Europe and the slowdown in China have hampered hopes for global economic growth, dampening investors’ appetite for speculation in commodities. This coupled by restrictive monetary policies by emerging markets’ central banks has helped bring inflation under control. The safety trade towards the dollar however, has had a negative effect on their currencies causing the value of ELD to drop as it is inversely correlated with the U.S. Dollar Index.

The following chart shows the relationship of ELD with the dollar index:

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(Click to enlarge)

Due to the failure of the super-committee to reach an agreement, and weakening of European bond markets, volatility is expected to rise in the near future strengthening the dollar. This is why I recommend shorting ELD now, or waiting for a better entry point.

Long-Term Outlook

As the crisis unfolds and volatility decreases, the safety trade will fade and the dollar will lose its value. The Fed will not mind this move. Neither will the U.S. government because a weaker dollar will reduce the American trade deficit by increasing exports, and reduce the debt burden. There is an expectation that the currencies of emerging nations will rise in value in the long run because of pressure by developed nations to balance trade, and because of rising demand for imports by an ever growing middle class in those countries. All these factors are a positive for ELD.

In my next article I will discuss the economies and currencies of each of the countries in ELD’s portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.