Despite seemingly high yields, today is not a particularly attractive time to buy emerging markets debt, whether hard currency or local currency. Although EM debt is less volatile and lower beta than EM equities, given current valuations and currency exposures, we still find EM equities more attractive than debt, especially on a multi-year horizon.

On an index basis,^[1]We use the JP Morgan family of emerging markets debt indexes, specifically the EMBI Global Diversified (US$-government bonds), the CEMBI Diversified (US$-corporate bonds), and the GBI-EM Global … Continue reading US$-denominated EM sovereign and corporate bonds are yielding around 6% and local currency EM government bonds around 7%, all of which are in line with or slightly below post-2001 medians. Spreads to US Treasuries are somewhat elevated, but by no means extreme. To us this implies that EM debt is fairly valued and may be adequately priced for any near-term rise in US interest rates, but does not offer compelling value, unlike in 2008, 2001, and 1998. In contrast, EM equity valuations are depressed, offering a normalized earnings yield (the inverse of the return on equity–adjusted price-earnings ratio) of 8%, a rare premium to EM debt yields. Historically, EM debt yields have been higher than EM equity earnings yields, especially for US$-denominated EM debt. Thus, valuations today favor EM equities.

We currently view EM currencies as slightly undervalued but expect them to remain weak over the next few years amid a strong US dollar and weak commodity prices. The composition of the EM debt universe is heavily tilted toward commodity exporters and current account deficit countries, while EM equities are heavily tilted toward Asia (70%), where countries are primarily commodity importers and have current account surpluses. Thus, we view Asian currencies as fundamentally more sound than non-Asian currencies, and therefore EM equity currency exposure as less vulnerable than EM debt currency exposure.

What about China? EM equities are heavily exposed to China, while EM debt indexes have surprisingly little direct exposure. Given investment restrictions, China has a 0% weight in the investible version of the EM local currency government bond index used by most EM debt managers, and only a 6% weight in the US$-denominated EM government bond index. China is a more substantial 20% of the broad US$-denominated EM corporate bond index.

Access to China’s domestic fixed income market lies at the heart of the decision to allow the renminbi (RMB) to join the International Monetary Fund’s special drawing rights (SDR) basket, a designation that will require central banks to hold RMB-denominated fixed income as part of their reserves. The IMF has just announced inclusion of the RMB in the SDR, with a weight of 10.92% taking effect October 1, 2016. Nevertheless, the impact of SDR inclusion is largely symbolic. Prior to the announcement, Goldman Sachs calculated that a 15% weight for the RMB would result in only US$40 billion in SDR-related flows, and potentially much lower, since global central banks already hold an estimated US$100 billion worth of RMB in reserves. Instead, SDR inclusion acknowledges China as a major part of the global financial system, validating the progress made so far in reforming and opening its financial markets, and hopefully encouraging more liberalization.

We expect the opening of China’s domestic markets not only to occur gradually, but also to weigh on the RMB as domestic investors diversify abroad. A weak RMB could put downward pressure on other EM currencies, which will impact all EM asset classes. Yet the biggest risk in emerging markets today is not currency weakness but defaults in the corporate debt space, which has grown rapidly post-2008. The most vulnerable sector is commodity-related debt, and particularly that of Petrobras in Brazil. While a case can be made for avoiding EM corporate debt in favor of sovereign debt, this may be an oversimplification, given the wide dispersion in fundamentals across countries, sectors, and currencies. Instead of picking one segment over another, broad open-mandate EM debt managers will have the best ability to add value in the EM debt space and help investors navigate what will be a difficult period for EM economies over the next two years or so. Yet given current valuations, we’d prefer to gain exposure to EM economies and currencies via EM equities, recognizing such exposure may be more volatile in the short term.

Aaron Costello is a Managing Director on the Cambridge Associates Global Investment Research team.