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Our story begins in 2013, when the US Federal Reserve (Fed) began the slow extrication from quantitative easing amid the famous "taper tantrum". EM currencies took the brunt of the damage as the dollar began a massive 20% or so rally.

Over the three years of 2013-2015, the cumulative performance of the local currency index was negative 29.6%. Currencies in the index were down on a nominal basis, on average, 50%. Unlike other deeply negative environments for EM, there was not a single blow-up or risk catalyst like the Mexican peso crisis of 1994, the Asian financial crisis of 1997, or a US equity crash. It was just a slow painful bleed that by contrast seemed to happen in a somewhat stealthy manner. That, and the fact that there was no serious default or credit crisis in the asset class, allowed this period to go under-appreciated as a painful adjustment phase. But quietly painful it was, and broadly speaking foreign exchange reserves fell, inflation rose sharply and interest rates had to rise in response, with growth also declining.

The turning point

In hindsight, it now seems like January 2016 marked a turning point, as the Fed put off a series of interest rate hikes in response to global growth fears and the dollar stabilised. The local currency index rose 9.9% for the year, but that was only in line with the rest of the major EMD indices. Today, even though the Fed is hiking rates, other developed market (DM) central banks are heading in the same direction, and perhaps the Trump administration's focus on trade is keeping the dollar subdued.

Attractive EM real interest rates drawing capital

With that background, 2016 seems today like a quiet healing year. In 2017, we are seeing the unwinding of this negative cycle gaining speed. Even as EM growth stabilises at twice the growth rate of DM economies, EM inflation is falling towards developed levels (see chart below). That is making real interest rates attractive, especially relative to DM, and is drawing capital. This is leading to appreciation in EM currencies and allowing their central banks to cut interest rates. Furthermore, foreign exchange reserves are rising, serving as a building block to improving credit quality.

Inflation in EM vs DM, year-on-year 2005-2017

Source: Datastream, March 2017

Improving EM credit quality

Because of the severity of the currency fall that preceded this period, the runway seems long for a virtuous cycle. The inflation story becomes important, because the convergence suggests that real rates on a comparative basis will continue to be attractive in EM through a pronounced currency appreciation cycle. In the meantime, overall credit quality of EM versus DM should continue to improve. Little wonder that last week's retail funds flow data from EPFR Global showed the strongest positive flows since last July. So even if dollar debt spreads began the year at historically somewhat rich levels relative to DM, relative improvement in EM credit quality suggests that more tightening can happen, and local currency returns could be extremely generous in selected countries.