Market Views: Fixed Income

EMD Relative weekly notes

Week Ending April 8, 2016


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Emerging market assets have indeed come a long way this year. Local currency GBI-EM index returns have been 11.02% to date, dollar EMBIG sovereign returns 5.22%, and dollar corporate CEMBI returns 3.89%. That’s a good year’s work in just over three months. When investors step back and see those out-sized returns, they have to wonder about sustainability and the risk-reward proposition. We have seen most commentators remarking that the fundamental improvement in the asset class does not justify such gains, and they urge caution from here.

We believe that assuming a linkage between a fundamental asset class view predicated on an opinion on future growth prospects and future asset price gains is, in this particular asset class, always a flawed way to analyze things.

We have frequently pointed out that liquidity is the key to asset prices, and liquidity has come back into the asset class in a big way. We now have witnessed seven consecutive weekly inflows into dedicated mutual funds, with the four-week average jumping to $1.1 billion. More importantly to us, given the high correlation to asset prices, is the change in currency reserves across the asset class, which has been strongly positive. Over our two-and-one-half decades in this asset class, it has often been the case that emerging markets flip from virtuous to vicious cycles and back. Vicious is when reserves flee, currencies decline, interest rates subsequently rise, and economic stress results. That fairly accurately describes the mid-2013 to January 2016 period in EM. From that point to now, we are factually in a virtuous cycle of rising reserves and appreciating currencies—though it is important to note that real economic benefits have yet to be manifested.

The driver is the US dollar. The following chart shows the dollar index against the price of the GBI-EM local currency index. The dollar index (DXY) has fallen 4.23% since March 1st, powering EM local currency to a 9% gain in that month alone. The Fed has been a key catalyst with a dovish tilt that has surprised markets in a favorable way but it has not been the only catalyst, and this is something we think the market does not fully appreciate. The Euro has risen against the dollar in part because the ECB stepped away from a reliance on negative interest rates to more of a focus on asset purchases—signaling to the market that it no longer considers a weak Euro to be a key policy objective. The rise in the yen against the dollar is a bit more puzzling, but is a potential sign of waning market confidence that the BOJ can engineer a reliably weaker currency. Add to this interplay of factors a softer dollar that has eased pressure on the CNY to depreciate—the currency has in fact appreciated since March 1st—and global factors can be seen to be very supportive for emerging markets.

Oil also remains supportive. This week the oil market started by focusing on whether OPEC could freeze production, and ended by focusing on US oil inventory drawdowns versus expectations of healthy builds. That has boosted the price of oil towards its near-term $40 high. That represents a positive for EM sentiment and eventually EM liquidity flows.

If one wanted to guess as to the medium-term path of asset prices, you could point to the fact that growth remains a laggard, but that ignores the slow growth world we live in—where EM growth can’t approach historical levels because developed growth cannot either—and the drivers of the market. To avoid forecasting—in essence guessing—we are focused on the historically reliable indicators we see, and their drivers. In our view, they remain positive.