Emerging market local-currency assets remain attractive, and funding currencies should be more diversified

Overview

This report focuses on how to express investment views on global emerging market local-currency assets against the backdrop of renewed US dollar strength. The authors believe that relatively stronger US growth, elevated energy prices, repricing of core rates, and renewed market discussion of Fed hikes all support a rebound in the US dollar and create headwinds for emerging markets. However, EM fundamentals, the credibility of monetary and fiscal policy, and global investors' underallocation to EM local-currency assets still support maintaining exposure. The core recommendation is not to abandon the EM view, but to reduce the macro risk of single-US-dollar funding through more diversified funding currency arrangements.

Core views

First, the report remains constructive on emerging market currencies, arguing that even if the US dollar rebound continues, EM may still have room to outperform relative to G3. Second, investors broadly acknowledge improving fundamentals in EM local-currency assets and insufficient global allocation, but there is substantial disagreement over the outlook for the US dollar, the Fed path, and a decline in US Treasury yields. Third, if investors worry that the US dollar will continue to strengthen, long EM currency positions can be funded with an equal-weight basket of USD, EUR, and JPY rather than relying entirely on USD funding. Fourth, historical backtests show that basket funding is more robust than single funding currencies across multiple time windows; CAD performs well among single funding currencies, but the basket approach is more consistent. Fifth, regionally Latin America performs best, CEEMEA is mixed, and Asia remains relatively lagging.

Analysis framework

The report combines top-down macro judgment with asset return statistics: it first assesses the pressure that US growth, the US dollar, oil prices, and the Fed path place on emerging markets, then compares the performance of long EM returns under different funding currencies or funding baskets, supplemented by fund flows, FX options positioning, regional returns, and sovereign credit updates to gauge market conditions.

Methodology notes

• Macro strategyAn emerging market framework combining top-down and bottom-up analysis

  Use the US dollar, interest rates, oil prices, and US growth to assess external pressure, while using EM policy credibility, fundamentals, and allocation levels to evaluate endogenous support for assets.

  The report argues that a stronger US dollar suppresses USD-denominated or USD-benchmarked returns, but this does not mean emerging markets lack value relative to developed markets.

• Return statisticsComparison of funding currencies and funding baskets

  Compare the returns, volatility, Sharpe ratios, maximum drawdowns, and tail performance of long EM currency exposure funded in USD, EUR, JPY, CHF, AUD, CAD, and multiple developed-market currency baskets.

  The sample period runs from January 2010 to May 2026. The results are used for relative comparison and do not include transaction costs or specific execution strategies, so the relative attractiveness of basket strategies may be overstated.

• Risk-return metricsSharpe ratio, Calmar ratio, and hit ratio

  The Sharpe ratio measures return per unit of volatility, the Calmar ratio measures annualized return relative to maximum drawdown, and the hit ratio measures the share of trading days with positive returns.

  The report uses these metrics to assess the robustness of different funding schemes over long-term as well as 1-year, 3-year, and 5-year windows.

• Fund flows and positioningLocal-currency bond flow tracking and FX options positioning

  Observe investor flows and positioning in the US dollar and EM currencies through foreign holdings data for nine EM local-currency government bond markets and FX options data.

  The report notes that both flows and returns have been in neutral territory over the past six months. FX options data still show an investor bias toward long USD positions, but also increasing long exposure in some EM currencies.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• Emerging market local-currency FX exposure

  Core long view

  Strengths

  Improving fundamentals, greater policy credibility, and insufficient global investor allocation support medium-term attractiveness.

  Weaknesses

  A rebounding US dollar, relatively strong US growth, elevated oil prices, and Fed hiking expectations may weigh on short-term performance.

  Comparison

  Compared with pure USD funding, using G3 or multi-currency basket funding better isolates the EM asset view.

  Risks

  Further US dollar strength, weaker global risk appetite, and transaction costs above backtest assumptions.

• Equal-weight funding basket of USD/EUR/JPY

  Recommended risk diversification tool

  Strengths

  The report says it can generate relatively stable total returns over the next 12 months, and in long-term backtests its Sharpe ratio and drawdown profile are better than traditional USD funding.

  Weaknesses

  Basket execution and rebalancing may increase transaction costs, which are not included in the backtest.

  Comparison

  More robust than single funding currencies; versus the best-performing EUR funding this year, the Sharpe ratio is slightly lower but diversification is better.

  Risks

  Changes in correlations among G3 currencies, transaction costs, and inappropriate basket weight settings.

• EM longs funded in CAD

  A relatively better choice among single funding currencies

  Strengths

  Since 2010, annualized total return of 3.6%, volatility of 6.3%, Sharpe ratio of 0.58, and a maximum drawdown lower than USD, JPY, and CHF funding.

  Weaknesses

  It has not led in every recent 1-year time window, and a single currency still carries concentration risk.

  Comparison

  Performance is close to the best basket results, but consistency is inferior to basket funding.

  Risks

  The Canadian cycle, commodity prices, and CAD's own volatility may alter historical relationships.

• EM exposure funded in EUR

  The strongest funding method year to date

  Strengths

  Year to date, EM exposure funded in EUR has delivered strong returns and low volatility.

  Weaknesses

  Accurately selecting the best funding currency in advance is difficult.

  Comparison

  Short-term performance is better than the G3 basket, but the basket approach reduces timing and single-currency selection risk.

  Risks

  Changes in European growth and rate paths, or a rebound or increased volatility in EUR.

• Emerging market local-currency government bonds

  Object of fund flow and return observation

  Strengths

  Fund flow tracking is correlated with returns in local-currency government bond markets and is currently in neutral territory; if oil prices decline and global fixed-income stability improves, flows may recover.

  Weaknesses

  Fund flows in May were small, and year-to-date returns have pulled back from February highs.

  Comparison

  Latin America has broadly positive returns, CEEMEA is mixed, and Asia lags behind.

  Risks

  Oil prices, inflation, core rate repricing, and regional political risks.

• Emerging market sovereign credit

  Supplementary regional and country opportunity set

  Strengths

  Some markets such as Argentina, Mexico, and Nigeria are described constructively or with a bullish tilt, and EMDD fund flows have improved.

  Weaknesses

  Senegal faces risks of slower fiscal consolidation, delayed reforms, and debt restructuring.

  Comparison

  Overall EMBIG-D spreads were flat over the week, but performance diverged across ratings and regions.

  Risks

  Downgrades, changes in the IMF path, political elections, and sanctions-compliance risk.

Key data

• Historical backtest sample periodJanuary 2010 to May 2026Used to compare return statistics for long EM currency exposure under different single funding currencies and funding baskets.
• CAD funding performanceAnnualized total return 3.6%, volatility 6.3%, Sharpe ratio 0.58, maximum drawdown -12.3%Stands out among single funding currencies, with lower drawdown than USD, JPY, and CHF funding.
• Maximum drawdown of USD funding-28.8%The report compares this with CAD, JPY, and CHF funding schemes to emphasize the risk-control value of diversified funding.
• Tail performance of long EM versus CADWorst 3 months about -8.2%, worst 12 months about -8.4%The report argues that CAD funding historically improved returns without introducing the same degree of left-tail risk as JPY or CHF.
• Coverage of local-currency bond fund flows9 emerging markets, with data for 7 countries available as of May 29Flow tracking is used as a proxy to observe foreign investor trends in EM local-currency government bond markets.
• Rolling 3-month fund flowsFell from about US$40 billion in mid-February to about -US$20 billionThe report says this mainly reflects earlier inflows rolling out of the window, rather than new large-scale recent outflows.
• Year-to-date return of EM local-currency marketsAbout 1%Latin America is the main positive-return region, CEEMEA is mixed, and Asia remains behind.
• Hungary performanceYear-to-date return about 16%The report says Hungary is a standout performer within CEEMEA and the broader emerging market universe.
• EMDD fund flowsGlobal-dedicated EMDD funds saw inflows of US$907 million last week, after inflows of US$167 million the previous weekThis indicates some improvement in sovereign credit-related fund flows.
• EMBIG-D spread242bpEssentially unchanged over the past week; B-rated spreads widened the most, while BB-rated spreads tightened the most.

Impact & implications

For investors, the implication of this report is that if they acknowledge improving fundamentals in EM local-currency assets but worry about disruption from the US dollar and the Fed cycle, then the investment decision should be split into two parts. The long EM view can be retained, but the funding side does not need to be fully tied to the US dollar; using baskets such as USD, EUR, and JPY, or considering CAD among single currencies, can help reduce drawdowns and volatility. The report also reminds investors that historical statistics do not include transaction costs, so actual portfolio implementation needs to assess liquidity, funding costs, and rebalancing costs.

Risks

• A continued rebound in the US dollar would directly weigh on EM local-currency asset performance, especially for portfolios benchmarked to or funded in USD.
• Resilient US growth, US equity outperformance, and discussion of potential Fed hikes could reinforce the 'US exceptionalism' narrative and long USD positioning.
• High energy prices and inflation uncertainty could weaken risk appetite and limit improvements in global fixed-income stability.
• The report's backtest of funding currencies does not consider transaction costs or implementation details, so the historical advantages of basket funding may be overstated.
• Asian emerging markets continue to lag, and regional divergence may drag on overall EM index performance.
• At the country level there are political, fiscal, rating, and IMF program uncertainties, such as Colombian elections, Senegal's fiscal reforms, and Mexico's rating trend.
• Investment activities involving jurisdictions subject to economic sanctions require investors to ensure their own compliance.

What to watch

• Positioning changes in the US Dollar Index, BBDXY, and the broad dollar index, and whether investors remain biased long USD.
• US employment, inflation, core rate repricing, and the Fed policy path, especially whether rates remain unchanged in 2026 and whether cuts occur in 2027.
• Oil price trends and the stability of global fixed-income markets, because the report believes these will affect whether fund flows into EM local-currency bonds recover.
• Foreign holdings data for local-currency bonds in nine emerging markets, especially whether rolling 3-month fund flows rebound from low levels to neutral or turn positive.
• Positioning changes in EM currencies such as HUF, ZAR, PLN, CZK, MXN, TRY, and BRL in FX options data.
• Return divergence among Latin America, CEEMEA, and Asia, especially whether Latin America continues to lead and whether Asia recovers.
• Second-round election polls and endorsements in Colombia, Argentina's FX reserves, Mexico's rating, Senegal's IMF path, and Nigeria's reform and oil revenue performance.