Fixed Income

EMD Relative weekly notes

Week Ending May 18, 2018


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

This week Indonesia raised interest rates, Brazil's central bank stayed on hold versus expectations of a cut, and Colombia signaled its cutting cycle was now over. Our sense is that this represents the end of a broad positive monetary cycle across emerging markets triggered in January of 2016 by the end of a stratospheric rise in the US dollar from mid-2014 to that point.

What follows from the current episode of the sharp rise in the US dollar since April 16th, if history is any guide, will be a period of continuing currency depreciation that feeds into eventual higher inflation, rate hikes and—with a lag—slower growth numbers in EM. In the absence of a catalyst for turning the dollar around, EM local currency should be a very poor investment. Indeed, a broader history shows it has merit, but only as a more tactical addition and not as a primary allocation amongst EMD risk exposures. Since 2010, local has underperformed dollar debt in EM by generating 2.1% annually versus 6.5%, with a considerably worse volatility-adjusted return.

Despite that downbeat trend, value in EM dollar debt investing is opening up. None of the negative effects outlined above imply significantly higher default risks except in very isolated instances, something always forgotten in episodes of high price volatility.

The absolute yield of the EM sovereign dollar index is now currently 6.32% as of the date of this note. In the past five years, only the blow-out top of the negative 2015 period exceeded this level. The rising risk-free rate accounts for some of this, but spreads to US treasuries are still at 18-month highs.

However, particular value arises in non-default candidates with short-maturity debt possessing dollar prices somewhat below par and attractive yields relative to their rating category. The lower dollar price offers the ability to protect investors against extreme price volatility, the higher yield offers compensation if the risk-free rate continues to rise, and if the bonds are held to maturity one may see very attractive gains, all other factors being equal. Across the rating spectrum we see an array of these instruments, from double AA-rated Qatar to single B-rated Lebanon. Of course, these are simply examples, not any recommendation.

While we cannot know when the dollar might turn, we do see increasing headwinds towards significant additional tightening: slower growth outside the US, mortgage rates at seven-year highs and much higher gasoline prices within the US. While waiting for that moment which we think will certainly come, we also believe that the probability of positive returns for dollar EM bonds—and returns well above developed market bonds directly affected by rate hikes—is high. Of course, there can be no guarantees on future returns of any kind.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.