By Fran Rodilosso, head of fixed income ETF portfolio management at VanEck.

Fran Rodilosso, head of fixed income ETF portfolio management at VanEck.

Emerging markets local currency sovereign bonds delivered strong returns in 2017, which have primarily been driven by local interest rates rather than currency effects. We expect the same dynamic to play out in 2018. With generally stable or improving fundamentals in emerging markets and global growth, in our view, local currency bonds will receive support against higher interest rates in developed markets.

These higher rates are more likely to impact hard currency emerging markets fixed income sectors, although it is also important to remember that global monetary policy is still easy. The Fed’s balance sheet will only shrink marginally in 2018, while the European Central Bank’s and Bank of Japan’s will continue to expand.

Here are five scenarios in which we believe local currency bonds could perform even better:

• Brazilian reforms allow recovery to accelerate: Brazilian politics have been plagued by scandals in recent years, which have kept much needed structural reforms on the backburner. With the economy beginning to show signs of growth, it is time for actual progress in implementing these reforms.
• Political progress in South Africa: South Africa is among the weakest countries in the JP Morgan GBI-EM Global Core Index from a fiscal and economic perspective, which is reflected in its deteriorating credit ratings. However, the recent election of Cyril Ramaphosa as leader of the ruling party is a strong signal of progress, but executing on reforms may be challenging and take longer than expected.
• Resolution to Venezuela debt train wreck: Although no one was surprised by the Venezuela default, a transition to an earnest restructuring effort is needed. We expect the market to continue treating the debt problems as an isolated issue. That is not to say that this will do anything to address Venezuela’s deep political, social, and humanitarian problems.
• China keeps the balancing act going: Policymakers appear to have, so far, successfully pursued market rationalization and deleveraging in China’s financial sector without sparking a panicked market reaction. Continuing the deleveraging process without crushing growth will be key to global growth for 2018.
• Indexers proceed cautiously on China inclusion: Inclusion of Chinese local currency bonds in emerging market benchmark indices could result in over $250 billion of foreign investment. However, any reversal of recent policies that have opened up the market and eased limits on repatriation would cause a major market disruption.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)