Emma Wall: Hello, and welcome to the Morningstar series, "Ask the Expert." I'm Emma Wall and I'm joined today by Femi from Morningstar Investment Management to talk about emerging markets.

Hi, Femi.

Olufemi Mada: Hi, Emma.

Wall: So, it's been quite an eventful year for emerging markets. I thought before we look forward, we could perhaps recap over the last year. What has happened to emerging markets in 2018?

Mada: Yeah. It's definitely been a very tough time for emerging markets. But before, I think, I would like to stress that there are two ways that investors can get exposure to emerging markets. So, there's local currency side, which is bonds that are issued by governments within their own currencies. And then there's the hard currency debt, which is bonds that are issued by emerging markets but then in foreign currencies.

But whichever way you choose to look at it, it's definitely been a very tough year for emerging markets. So, the local currency bonds have been down by 10% year-to-date and the hard currency bonds have been down by 5% year-to-date which compares with the global aggregate bonds which is down by 1% year-to-date.

Wall: And what have been the drivers of those falls? Why have emerging market bonds done so badly this year?

Mada: So, there are three main factors you can think of. The first one is the dollar story. So, the dollar has actually rallied by 4%. So, in that environment, typically, emerging markets tend to underperform. And then compared with the emerging market local currency basket the dollar has actually rallied by 10%. So, that's definitely been one driver.

The second driver, you can also think about the current environment hasn't actually been favourable to trade. So, investors are actually worried about the ramifications of the constant trade threats that you are getting from the U.S.

The third factor is commodity rallies. So, when you look at where oil prices are year-to-date, compared with this time last year oil has actually rallied by close to 50%. So, when you combine these three main factors, it's actually exposed some vulnerabilities within some countries in the Emerging Markets Bond Index, so countries like Turkey, Argentina, South Africa and things like that.

Wall: But it doesn't sound like a very positive position for emerging market bonds to be in. As you say, you've got strong dollar, you've got worries about the trade war and you've also got the rising commodity prices. Do you think that these are enough reasons to be negative on the asset class? Or do you think there's a bit of kind of fear is overdone and they have slumped too much? What position are we in now going forward?

Mada: So, when you take the basket as a whole – so, the typical basket that investors look at when they are thinking about emerging markets is the EMBI Global Diversified Bond Index. When you look at that basket, there are a few countries that are clearly – they have issues. So, the countries I mentioned just now, so Turkey, Argentina and things like that. But it's much more than these countries. And those countries that I mentioned are actually a very small part of this index.

So, Turkey is only just about 3% of the Global Diversified Bond Index and Argentina is actually even less than 1%. So, even though Argentina has actually done minus 50% in USD terms year-to-date is actually – the impact on the total index is relatively muted. So, that's the first thing I would highlight.

But the second thing is, we have to think about the longer-term fundamentals. So, if you go back to 2013, where emerging markets as of today most of the countries within that index have actually improved their current account deficits. So, except for these fewer countries like Turkey and Brazil and things like that. That's the first thing.

Wall: So, fundamentals are strong?

Mada: So, the fundamentals are strong. Quite a few of the countries are improving their fundamentals and the growth story is actually still there which allows the countries to actually deleverage and improve their fiscal position over time. So, we think that the fundamentals are strong, and they are getting better.

So, if you go back to where emerging markets were like 10 years ago, a lot of the countries are now comfortable to issue bonds in their own currencies and the portion of their total bond issuance within their local currency is actually getting bigger and bigger. So, the fundamentals are strong. But there's this shorter-term impact of the headline news and that's driven volatility year-to-date.

Wall: Femi, thank you very much.

Mada: Thanks a lot, Emma.

Wall: This is Emma Wall for Morningstar. Thank you for watching.