Emerging Markets Local Debt: A Once-in-a-Generation Opportunity?

The U.S. dollar's overvaluation and the undervaluation of emerging market currencies have created a rare opportunity in local currency debt, according to GMO's latest analysis. Drawing parallels to the 2003–2011 period, the firm argues that investors who allocate now may capture asymmetric returns as currencies rebound and yields remain elevated. This article explores why the setup is exceptional, the risks investors must navigate, and why the time to act is now.

Valuation Metrics: USD Overvaluation as a Catalyst

GMO's analysis highlights that the U.S. dollar is currently “rich” relative to emerging market currencies—a condition last seen during the 2003–2011 period. The Behavioral Equilibrium Exchange Rate (BEER) model, which adjusts for structural economic factors, shows that EM currencies are undervalued by roughly 20–30% against the USD. This undervaluation sets the stage for a reversal, much like the 2000s when the dollar's decline fueled EM asset returns.

During the 2003–2011 period, the USD's depreciation boosted returns for EM equities and local debt by an average of 15% annually. Today, with the USD at multi-year highs, GMO argues that the pendulum is poised to swing back. This time, the tailwind is amplified by high local interest rates (e.g., Brazil at 13.75%, Turkey at 16.5%) and improving fiscal discipline in many EM economies.

Currency Appreciation: The Missing Piece in Traditional Portfolios

Local currency debt offers a unique lever to profit from currency appreciation—a component often missing in traditional EM equity allocations. While equities like those in the MSCI EM index are dominated by Asian markets (e.g., China, South Korea), local debt indices such as the J.P. Morgan GBI-EMGD include a broader mix of Latin American and CEEMEA (Central/Eastern Europe, Middle East, Africa) currencies. These regions, historically more volatile but higher yielding, now represent a diversified entry point.

Take Indonesia and India, both now 10%+ allocations in the GBI-EMGD. These economies boast stronger growth fundamentals (projected 5–6% GDP growth through 2028) and stable policy frameworks. Meanwhile, frontier markets like Jamaica and Costa Rica—underrepresented in equities but included in local debt benchmarks—offer frontier valuations with sovereign credit support.

Credit Spreads: Robust vs. Historical Defaults

Critics may point to EM's history of defaults, but GMO's data shows that current credit spreads are wider than historical averages, even in stressed regions like Latin America. For instance, Brazil's local bonds yield 14%, with spreads compensating for both inflation risk and political uncertainty. This contrasts with the 2000s, when spreads were tighter despite weaker fundamentals.

Tina Vandersteel, GMO's EM debt head, emphasizes that active management is key. “The GBI-EMGD isn't a passive play—it requires security selection to navigate idiosyncratic risks,” she notes. GMO's strategies, which emphasize frontier markets and country-specific analysis, have outperformed benchmarks by 200–300 basis points annually since 2020.

Risks: Sanctions, Liquidity, and Tail Events

No investment is without risk. Geopolitical tensions (e.g., China-U.S. trade friction), liquidity traps in frontier markets, and political instability (e.g., Turkey's crackdowns) remain concerns. GMO acknowledges these but argues that diversification and active management mitigate them. For example, Turkey's local bonds fell 10% in March 2025 due to election uncertainty, but this was offset by gains in Mexico and Indonesia.

China's Role: A Double-Edged Sword

China's inclusion in the GBI-EMGD (now 10% of the index) is both an opportunity and a risk. Its state-backed bonds offer stability and yield (3.0% for 10-year local debt), but investors must weigh geopolitical risks. GMO's analysis treats China as a core holding, arguing that its economic weight (20% of global GDP) and low correlation to U.S. Treasuries justify its place in the index.

The Bottom Line: Allocate Now, but Actively

The confluence of USD overvaluation, high yields, and improving growth fundamentals creates a setup unseen since 2004. While risks like sanctions and liquidity exist, GMO's historical data shows that EM local debt delivers the highest risk-adjusted returns during periods of dollar weakness—a scenario now in play.

Investors should consider a 20–30% allocation to EM local debt via active managers like GMO or PIMCO, who can exploit country-specific opportunities. Avoid passive ETFs (e.g., EMLC) that lack the flexibility to avoid sanctioned countries or capitalize on frontier markets. As Vandersteel warns: “This isn't a bet on every EM—it's about picking the right countries and timing the USD cycle.”

In a world of low yields and synchronized global slowdowns, EM local debt stands out as one of the few assets offering both growth and diversification. The question isn't whether to allocate, but how—and with whom—to do it.