EMLC - EMLC: Forget Gold Look To Foreign Currencies In 2024 - With A 6.4% Yield

2023-12-31 09:14:44 ET

Summary

• In 2023, the US dollar has remained strong despite weak fundamentals compared to emerging markets and developed countries.
• The US Dollar appears likely to reverse in 2024 as real interest rates reverse. Higher commodity prices may significantly accelerate that shift in favor of emerging markets.
• Most emerging market countries in EMLC have superior fiscal responsibility and trade balances compared to the US and Europe.
• EMLC appears superior to the dollar-backed EMB due to its lower duration risks and higher credit quality.
• While EMLC is not a low-risk fund, I believe it has strong potential to appreciate in 2024, providing a yield that is positively exposed to US inflation.

Most of the past decade has been marked by surprising strength in the US dollar compared to most other currencies. The reasons are vague but understandable upon close analysis. The US has a high public debt burden, tremendous net import expansion, a partially stagnated economy, and moderate inflation. Traditionally, all of those factors should lower the value of the US dollar compared to currencies, particularly from countries with high exports, high GDP growth, and lower public debt burdens. For the most part, many emerging market countries fit into the latter category but have had fragile currencies in recent years.

So, why is the US dollar so strong despite its generally weak fundamentals compared to emerging markets and most developed countries? About 80% of emerging market debt is priced in developed market currencies, primarily the US dollar. This practice encourages developed market investment in emerging markets by isolating currency risks that are historically high in some emerging markets.

Of course, most emerging markets also have lower public debt-to-GDP than the US, but that debt is a more significant burden due to higher interest rates. When inflationary factors rise in these countries, they often have more outstanding external obligations to pay, encouraging faster repayment of US-dollar-denominated debt burdens, which increase the value of the US dollar. Thus, a positive feedback loop has generally benefited the US dollar while creating some strains for emerging markets with high external debt levels.

I think much of this may change soon as the US faces inflation and interest rate strains. The strength of developed-market currencies over emerging currencies largely stemmed from lower inflation in developed markets. While it is true that inflation is reasonable today, I believe that the general level of inflation and the extreme increase in the monetary base over recent years dispel any myth that the US dollar is not exposed to debt monetization risk. As discussed regarding silver ( SLV ), there may be a decent risk in 2024 that the US will see its monetary base expand again due to banking issues, likely leading to a decline in the US dollar compared to commodities and emerging market currencies. Accordingly, emerging market local currency bonds, such as those in the ETF ( EMLC ), maybe one decent way to hedge that risk.

EMLC As a High-Reward Currency Hedge

EMLC is an interesting fund that has operated for over a decade but has never been a particularly popular ETF, with $3B in assets. I viewed the fund as a hedge against QE risks in 2020 but downgraded my view a year later. The fund is similar to the US-dollar-backed emerging market bond ETF ( EMB ), which is far more popular but differs by its local currency status. Due primarily to the US dollar's comparative strength, EMB has significantly outperformed EMLC since inception, though the two are highly correlated. See below:

EMLC's underperformance compared to EMB was particularly notable from 2012 to 2016. Over that time, the value of most commodities, including metals, foods, and energy products, crashed, leading to much lower inflation in the US and most developed markets. That crash also lowered the export value for many commodity-producing EMs and slowed the import price growth in the US. The US trade deficit generally has a strong inverse correlation to commodity prices and the inflation outlook (also correlated to commodities). See below:

The improvement in the US trade balance since 2021 is mainly attributable to the reversal in most commodities since the COVID shortages slowed. This is a notable relationship because it shows the general risk of the US currency in the event of another increase in commodity prices, which could quickly occur with global shipping geopolitical issues.

Of course, one of the primary factors promoting the US dollar over the past two years has been the sharp increase in real interest rates. The US has had a sharper increase in real interest rates (or rates after expected inflation) than most other developed markets, which have not increased rates so quickly, with Japan being the most notable example. As the Federal Reserve looks toward a dovish pivot, we're starting to see signs of reversal in the real interest rate. Accordingly, the US dollar is beginning to lose ground against its developed market peers. See below:

While the ETF ( UUP ) specifically relates to the US dollar exchange rate to other Western economies, it is also the primary driver of emerging market local currency values. To a large extent, an increase in the US dollar drives EM currencies lower due to higher external debt burdens. Turkey is a notable example of this issue, as seen in its nearly chronic debt crisis despite only having a 31% debt-to-GDP, mainly due to previously using excess dollar-denominated debt. However, as the US dollar reverses, we can expect that countries like Turkey will have an easier time paying down this debt.

In my view, there is a high probability we see the US dollar reverse from its 2023 peak next year. The downside risk in the dollar depends largely on actions in the commodity market, with geopolitical strife potentially being a significant commodity bullish and US dollar bearish event. Even if that does not occur, the US still faces the banking liquidity issue , which remains a substantial threat despite seeing less coverage in recent months. Additionally, the US dollar may naturally reverse as other countries raise interest rates while the US Federal Reserve looks toward eventual cuts. Combining these factors could create an immense US dollar downside, but even one should be enough to lift the value of EM currencies to an extent.

EMLC Risk Compared to Yield Potential

When people think of emerging markets, particularly EM currencies, they often imagine highly corrupt governments with weak economies. Of course, that is a factor to consider, but I would not imagine the US or Europe are so much better. The US has a public debt-to-GDP of 130%, and the Euro Area's is around 95%. Both have weak exports, chronic deficit spending, subpar economic growth, and elevated inflation. The US and European central banks are also quick to use money creation policies such as QE in recessionary periods, a practice that can lead to runaway inflation if overutilized.

EMLC's top holdings are China (9.7%), Mexico (9.3%), Indonesia (9.1%), Brazil (7.9%), and Malaysia (7.7%). In order, the public debt-to-GDP of these countries is 77% (China), 49% (Mexico), 40% (Indonesia), 72% (Brazil), and 60% (Malaysia). The trade balance is positive in all five of these countries. Inflation in these five countries is -0.50% (China), 4.3% (Mexico), 2.86% (Indonesia), 4.7% (Brazil), and 1.5% (Malaysia). In general, these are lower inflation rates that these countries saw in years past and partly below that of the US (3.2%) and the European Union (3.1%). Interest rates in these countries are generally similar, with Mexico and Brazil being around 11.5%.

While there is a negative perception regarding these emerging markets, the fact is that they're generally superior on most fundamental currency power metrics. Indeed, South American and East Asian countries typically have far superior fiscal responsibility than the US and Europe, with positive trade balances. The only thing they lack is the fiat currency status of the US, which gives others the need to use dollar-denominated external debt. In my view, this status is the only reason the US dollar is as strong as it has been, but it could quickly fade if the US faces the factors mentioned earlier.

EMLC has a YTM of ~6.9% today and an SEC yield of ~6.4%. The dollar-denominated equivalent EMB has a YTM of ~6.8% and an SEC yield of 6.6%, giving it roughly the same return profile as EMLC. EMLC's years to maturity is 7.1 with a duration of 4.9X, while EMB's years to maturity is 12.1 years with a duration of 7.2X. Accordingly, EMLC has notably lower exposure to changes in interest rates, with around 70% of the expected volatility to a change in rates. Lastly, 70.4% of EMLC's holdings are investment grade, compared to 52% in EMB, which has far more BB and B-rated bonds. Overall, this gives EMLC a lower interest rate and credit risk profile than EMB, with a similar rate of return, making it a potentially superior investment.

The Bottom Line

Overall, I am bullish on EMLC and have made the fund one of my significant holdings going into 2024. EMLC is undoubtedly not a fund anyone will get rich investing in, nor is it a particularly low-risk investment. That said, it has tremendous inverse exposure to the US dollar, which I believe may be very important going into the new year, as seen in the recent reversal in most dollar indices. Further, EMLC has a comparatively high yield given that so much of it is in investment-grade countries with notably superior fiscal responsibility and trade balances than the US.

One additional benefit of EMLC is that its yield will not decline if its price rises due to currency appreciation. EMLC's yields are based on local currencies, so an increase in the value of those currencies compared to the US dollar should cause its dividends to rise proportionately. This is one significant benefit to EMLC that is rare amongst fixed-income investments. Of course, its dividend can also decline if those currencies lose value, so it is also a risk factor.

The most significant risk to EMLC is a "blow-off top" increase in the US dollar exchange rate. That would require a financial crisis in emerging markets, which I believe is generally unlikely. I believe the US dollar "blow-off top" likely occurred this year and is now headed into a sharp reversal. Still, my view goes against the historical trend of dollar strength and EM currency weakness. While I believe that trend will likely reverse sharply in 2024, there remains a risk that my view is "too early," as I'm betting on a trend that does not yet firmly exist.

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