Scenario 1: a central bank runs excessively loose monetary policy for 18 months despite U.S. monetary policy tightening. This causes the currency to depreciate by 30-40% against the U.S. dollar. A few people guessed correctly — this is a developed market (Japan). In aggregate, developed market currencies underperformed emerging market currencies in 2022 as the U.S. started hiking rates, and the Japanese yen was the prime example of this; emerging market economies were generally ahead of the hiking cycle, but Japan kept running excessively loose policy and maintained yield-curve control. As the Fed aggressively tackled inflation, the best option for asset allocators was to sell protected and over-valued Japanese bonds, and in turn the yen sold off.
Scenario 2: policymakers unveil an unfunded fiscal dash for growth, resulting in a 70% devaluation in local currency bonds. A few more people got this one right — the U.K.. Early in 2021, long-dated gilts traded at par; now they're around 30 pence to the pound. At the same time, sterling fell to parity with the U.S. dollar; a dollar investor owning long-dated gilts lost about 80% of their mark-to-market value at one stage. From my experience in trading in debt markets, these types of moves would typically be reserved for emerging markets rather than what were once considered safe-haven markets.
Beyond these extreme scenarios, policymakers across emerging markets — with exceptions, of course — have proven their orthodox credentials in various ways over the past few years. This is evidenced in proactive rate hiking: when inflation turned up in emerging markets, central banks hiked; when it turned up in developed markets, they called it "transitory." It is also seen in fiscal prudence by emerging markets policymakers, even as inflation spurred nominal growth — resulting in primary fiscal balances being in surplus across many emerging markets economies in 2022 and debt-to-GDP stabilizing at modest levels. After more than a decade of unconventional policy in developed markets, emerging markets economies stack up considerably better across many fundamental metrics.
And it's not just through a policymaking perspective that the lines appear to be blurring between emerging and developed markets. Let's consider the perception that emerging markets are not worth the risk. Looking at a 20-year time frame, we consider the preferred local index for emerging markets debt — the J.P. Morgan Government Bond Index-Emerging Markets Global Diversified, which includes 20 countries and currencies. For developed markets, we use the J.P. Morgan GBI-Broad index. From this we measured the seven largest developed bond markets with different currencies to best represent asset-owner portfolios. Both indexes are unhedged in U.S. dollars, and we have also removed any duration bias by using the five to seven-year bucket for each index. As Figure 1 shows, emerging markets debt market volatility — naturally higher than developed markets — has not really changed throughout the bond market turbulence of the last few years. But developed markets debt appears to have broken out of the last decade's calm and entered a new regime — with markets like U.S. Treasuries, U.K. gilts and the Japanese currency exhibiting significant volatility. While developed bonds still have much to offer investors as a defensive core allocation, in this uncertain world of heightened volatility, it is not emerging markets debt that has changed, it is developed markets.