Fixed Income

EMD Relative weekly notes

Week Ending May 26, 2017


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Flows into emerging markets continued apace this week, with over $1 billion in retail inflows for a 10th straight week. The flows of liquidity into the asset class continue to find their way into rising foreign exchange reserve levels, which continue to spur fundamental improvements by lifting currencies and allowing central banks to lower interest rates. Mexico has been the notable outlier but after what is likely to be a final rate hike at the next central bank meeting, we expect inflation there to roll over and allow rate cuts later this year--that has been the pattern across virtually the entire asset class.

In previous historical cycles, this virtuous loop has often contained the seeds of its own destruction, as currencies became over-appreciated, external deficits soared and some precipitating event on a macro level turned flows around, leaving countries vulnerable to quick deterioration. We are not seeing any signs of that despite the generous returns the asset class has historically offered investors since early 2016. Turkey and South Africa are good examples: in 2013 as the Fed's “taper tantrum” erupted, the two were poster children for the "fragile five" countries with large external deficits. Yet currently both are actually continuing to shrink current account deficits, as is Brazil.

What is different this time is the nature of the flows. As ETFs play a larger role, value opportunities are changing, we believe. The largest passive ETF for EMD has grown assets by $3.5 billion this year alone and by $7.5 billion since emerging markets began to perform in early 2016.

Those investors are increasingly accessing the least interesting part of the opportunity set, in our opinion, by buying the mainstream sovereign index passively. Corporate debt grows increasingly more attractive, from a relative value perspective, as it underperforms. The chart below shows how, per unit of duration, every part of the credit spectrum offers more value than sovereign debt--and this disparity is only growing. Additionally, in a weak to stable dollar environment, local currency investing has the ability to offer the opportunity for additional total return via currency appreciation as well as better starting yields.

Source: JPMorgan and Bloomberg; Indexes are JPMorgan EMBI Global Diversified and JPMorgan CEMBI Broad Diversified, each are weidely used proxies of their respective asset class. Option Adujusted Spread (“Spread”) refers to the yield pick up over a risk-free rate. Duration is shown in years. S/D refers to spread over duration. Spread and duration are measured to worst. Data as of May 25, 2017, and will fluctuate over time.

As long as current conditions hold, we think its reasonable to expect that passive investors may outperform many active managers who are benchmarked against a sovereign EM Index, but they are also quite likely to underperform the broader opportunity set available to EMD investors, should the dollar decline, or even remain stable. And that fact is unlikely to be recognized by the vast majority of investors who own such passive ETFs Nevertheless, their steady inflow will allow fundamentals in every part of the opportunity set to continue to improve--benefiting others disproportionately.

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.