Fixed Income

EMD Relative weekly notes: Week Ending January 18, 2019

Week Ending January 18, 2019


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Characteristics of an early stage EM rally

In our view, there can be no serious quarrel with the fact that emerging market assets appeared to have turned a corner after an extremely poor 2018. The local currency index has gained nearly 7% in 10 weeks. Though dollar spreads are only flat during the same period, they have yielded a positive return of over 3%.

The first thing potential EMD investors should ask is whether this rally leads to the type of dynamics within the asset class that preview fundamental improvement—the essential ingredient to more sustained gains. So far the evidence suggests to us that it does.

Most importantly, foreign exchange reserves continue to rise sharply, after consolidating late last year. Figure 1 shows the rate of change of the aggregate level of those reserves across a broad swath of countries (ex-China), along with the change in the sovereign dollar index. When reserves rise, creditworthiness improves, currencies are rising to stable in value, and external deficits are likely not threateningly large. Though this might not be validated by credit rating agencies in the near or even medium term, the movement of asset prices shows this improvement is well understood by markets.

Source: Source: Local central banks, Haver, Bloomberg; data are most recent as of January 18, 2019. Past performance is not a guarantee of future results. Actual results would vary.

The next step would be for central banks across the EM asset class to abandon rate hiking cycles where they were implemented to stabilize currencies in a declining environment. We have already seen this occur in Turkey and Argentina, the two countries most severely affected by the strong dollar of 2018. We are now seeing Indonesia, Mexico and South African central banks heading definitively towards the sideline.

Following this we would expect to see central banks signal, and then implement, rate cuts. Lastly, we feel those rate cuts, the ability to access markets for favorable refinancing of debt, and better GDP growth, would justify further yield compression in the asset class.

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.