Market Views: Fixed Income

EMD Relative weekly notes

Week Ending July 29, 2016


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

For the traditional drivers of EMD performance, this was a good week:

• First, the US Federal Reserve passed on an opportunity to materially raise rate hike probabilities as perceived by the market. To be fair, the market had spent the last two weeks gradually raising these odds, so after the meeting the odds essentially flat-lined. The result was to remove a risk factor for EM and EM FX. On Friday, a Q2 GDP number substantially below expectations shifted the dynamic in a more positive direction as the US dollar weakened and rate hike expectations unwound—we view that as an unambiguous plus for EM FX.

• Secondly and less appreciated, the Bank of Japan passed on meaningfully ramping up monetary stimulus. Thus, it is becoming clear that major central banks are abandoning the tactic of leaning on negative interest rates to boost growth, and shifting towards a greater reliance on asset purchases—and presumably future fiscal stimulus. We forecast two implications for emerging markets: 1) the lesser reliance on negative interest rates lowers the probability of a strong dollar as US growth lags—a big positive for EM in our opinion; and 2) the reliance on asset purchases means "spread" product—with attractive yields above government bonds—will continue to be purchased and the largest liquid opportunity set resides in EMD.

• Finally, retail flows into mutual funds remain substantial, with a fourth consecutive week of flows over $2.6B. We believe in this cycle institutional investors are actually lagging retail investors in recognizing the positive effects of greater liquidity into the asset class, and we expect in the second half of this year the diminished possibility for income elsewhere globally may lead to greater EMD allocations structurally.

Potential investors may well look at year-to-date returns and balk: the EM dollar sovereign index is up about 12.5% and the EM local currency index is up over 13%. But the attached chart shows that spreads on sovereign investment grade is merely at its five year average—hardly extended. When one adds in an analysis of the brave new world of Quantitative Easing and its consequences, going forward returns for EMD, in our view, should remain relatively attractive compared to other global income opportunities.

Source: Bloomberg; JPMorgan EMBI Global Diversified Index Investment Grade spread versus US Treasuries; as at 28 July 2016. Past performance is no guarantee of future trends and results.