Threadneedle update on emerging market local fund first quarter

Richard House, Threadneedle's Emerging Market Local Fund Manager, comments on the current market conditions and the fund's first quarter performance following launch:

Market background

"We have seen a consistent theme across the Emerging Markets (EM) world over the past six months, namely negative inflation surprises driven largely by food and energy shocks and this has continued throughout March. Indeed, a number of central banks have raised interest rates to stem this inflationary pressure, in particular Hungary and Poland.

"Generally, local bond markets have continued to underperform FX - the JPM GBI-EM Global Diversified index lost 89bp in US dollar terms during March. Whilst on the other hand, EM FX has continued to perform well returning a positive 132bp in USD terms (JPM ELMI+) over the same period."

Performance and commentary

"During March, the fund return was broadly flat in US dollar terms, slightly underperforming its composite benchmark.

"A main strategic theme for the fund has been to underweight those countries with large funding needs, measured by a country's basic balance (current account surplus/deficit plus foreign direct investment). Negative basic balances imply that a country needs to rely on foreign capital to finance its deficit, and given the current liquidity crisis affecting global markets, financing such deficits is going to prove to be increasingly difficult. With diminished access to foreign sources of capital, demand for foreign currency in the FX market will grow, in turn leading to a weakening of domestic currency."

Market outlook

"We continue to be concerned about headline inflation across most of the EM world. Commodity prices, most notably soft commodities and energy, continue to rise. Negative inflation surprises are therefore likely to continue. As a result, we will continue to hold our underweight duration position and overweight FX position.

"However, we believe that at some point EM local markets will start to react to the lower growth outlook as opposed to the current inflation shock, essentially following what is now happening in developed bond markets. In this environment bonds will start to post significant gains. In particular, we will focus on those bond markets where we believe the tightening cycle to be at/or close to an end, particularly Poland and Colombia.

"We expect the currencies of high deficit countries to continue underperforming those currencies with low or no financing needs."