Fixed Income

EMD Relative weekly notes

Week Ending May 19, 2017

05/24/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

When is political noise a reason to reduce risk, and when does it carry no significant import? The answer, we feel, is when the primary drivers of asset price valuation remain in place. That was the case for emerging market assets this week in the wake of the President Trump news and the President Temer of Brazil news.

The US news resulted in a one-day equity correction and a shaking of risk assets, but most importantly for EMD investors the dollar's slide actually seemed to accelerate this week. The DXY US Dollar index finished down 2% for the week, the worst individual week since April 2016, wiping out all the gains of the Trump presidency so far. Additionally, treasury yields fell 10 basis points for long bonds.

Both of those factors were supportive for EMD assets, and their price moves are the reason we are generally sanguine about the political noise emanating from Brazil. The president was reputedly caught on tape encouraging the payment of hush money to a jailed politician. That news came out late Wednesday, and investors shot first and asked questions later the following day, sending the currency down 8% at one point and newly issued ten year Petrobras bonds down 8 points at their low.

While the accusations do indeed raise near-term political uncertainties, it seems apparent the sterling economic team will stay in place and that the reform agenda--while clearly wounded--is not dead yet. More broadly, lots of mainstream financial press has suggested the possibility for contagion to the rest of the asset class.

The dollar and well-behaved treasury yields suggest that fear is highly unlikely. We believe that value has opened up in Brazilian assets and we incrementally expanded our holdings this week after the noise. Why? First, the initial reaction in local rates wiped out the pricing of any interest rate cuts this yearin our opinion a clear over-reaction given a structural decline in inflation, unless the currency were to completely fly off the rails. Secondly, the dollar's decline remained intact, which if history is any guide will induce liquidity to flow into the asset class. What was probably a two standard deviation fall in price should thus have a high probability of correcting when positive broad factors remain intact we expect.

Therefore, we continue to see a supportive environment for the asset class from the perspective of focusing on signals rather than noise.

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.