Summary
Key points
The breakdown in the long-held relationship between US assets and the US dollar signals a deterioration in its safe haven status. While the dollar’s reserve currency status is unlikely to be seriously challenged in the foreseeable future, we see evidence of a rebalancing in global capital flows. As investors assess where to spend their marginal investment, we see the beginning of a shift in allocations away from US assets. Hedge ratios on USD assets have increased this year after decades of peak allocations benefiting from American exceptionalism.
Emerging Markets Local Currency Debt is well positioned to capture this shift in global capital flows, following years of underinvestment by asset allocators and strong performance this year (greater than 10% YTD). Today, the asset class benefits from robust fundamentals, limited foreign investor participation, improved governance, light investor positioning and attractive valuations. Any demand shock from tariffs would lead to lower growth and inflation across EM, which enables policy rate cuts and positive returns from EM duration.
EM real rates are at decade highs relative to DM, and a weaker dollar supports EM currencies, even as most EM central banks have built up credibility over time and several have moved to inflation-targeting frameworks.
Policy uncertainty can be a real disruptor. Back in 2018-19, proposed US tariffs on China was a challenge faced by an e-commerce company that sold ergonomic office accessories. One of their best-selling products directly impacted was a gas-spring monitor. When the US announced tariffs on Chinese imports, the company was caught in the cross fire–unsure whether to stockpile inventory, switch suppliers, or wait it out. By the time they acted, competitors with more agile supply chains had taken market share. That experience reinforces how policy uncertainty–not just the policy itself–can also be a real disruptor.
President Trump’s rolling tariff announcements have only elevated policy uncertainty this year. They will be back into focus in the summer with more economic uncertainty with the Big Beautiful Bill. Despite the back-and-forth, tariff policy de-escalation has allowed risk assets to recover through the month of May, with a corresponding shift in the flavour of the dollar move, more DXY stability. Yet if the trade détente reverses, or if fiscal concerns and foreign taxes take centre stage, this is likely to shift again.
In this edition of the Investor Diary, we argue a medium-term constructive case for an allocation to Emerging Markets Local Currency Debt.
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