Emerging Markets Bonds May Protect Purchasing Power of U.S. Investors

At Pilot Capital one of our concerns going forward is the value of the U.S. Dollar relative to its peers (Yen, Euro, and Pound) and to the currencies of developing markets. We believe that, over the next several years, the dollar will continue to be weak because of the still-large (although shrinking) U.S. trade deficit, our very large (and growing) national debt, and the anemic U.S. economic growth that we foresee. This has profound implications for the financial well being of our clients, whose wealth is denominated in U.S. dollars. Remember that we all operate in a global economy (we buy lots of stuff from folks in other countries and we depend on them to buy things from us). Any decline in the dollar versus the currencies of our trading partners lowers your purchasing power relative to the folks we are buying from and selling to, an uncomfortable situation. This makes it important that we look for a hedge against a chronically declining dollar. It would also be helpful if we were being paid to hold this hedge.

When looking for what currencies would represent a good hedge against a declining dollar, we rejected the other developed market currencies as many are in the same situation as the dollar. In fact, there is the strong possibility that developed market currencies will “lock” over the next few years and essentially move together eliminating any diversification advantage.
Many emerging markets countries, on the other hand, run trade surpluses, are less indebted to the rest of the world, and are likely to grow faster than the U.S. and the rest of the developed world in the foreseeable future. The most visible examples of this are Brazil, India and China. In addition, emerging-markets currencies offer higher yields, which attract the capital flows that support their currencies. Longer term, as the balance of the global economy shifts, it may become increasingly in emerging-market countries’ self-interest to allow their currencies to appreciate versus the dollar (currently many peg their currencies to the dollar) in order to improve the purchasing power of their consumers. Taking into account all these factors, we believe that a basket of emerging-markets currencies is the best way to protect our balanced portfolios from a decline in the U.S. dollar. The best way to achieve this goal is to own a diversified portfolio of good quality bonds denominated in (interest payments are made in) a variety of these currencies. If global economic recovery continues and the dollar continues to weaken we would profit in three ways.

· First, we are being paid our interest in the local currencies. For this income to be returned to us it must be converted to dollars. If the dollar cheapens versus the local currencies we can buy more dollars (hence preserving our spending power).

· Second, rates are much higher in developing countries than in the U.S. and the yield curve much steeper (a bigger difference between short and long term rates) this gives a good, active manager an opportunity to use interest rate risk strategies to add value.

· Third, we believe that the perception of risk in these markets will decline over the next few years and there may be more demand for debt from these countries allowing for capital gains.

When looking for an investment vehicle to position this hedge we favor active managers and not indexed funds (note that this effectively eliminates ETF’s). An active manager is able to take full advantage of the steeper yield curves available in emerging bond markets as well assess currency weightings in the portfolio to maximize currency translations versus the dollar.