Fixed Income

EMD Relative weekly notes

Week Ending January 12, 2018

01/17/2018

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

One of the basic tenets of behavioral finance is that investors tend to let losers linger too long, and tend to cut short winners too soon.  The tendency to view forward looking prospects by looking at past returns is almost too tempting to resist.  So when an asset class has performed well over an extended period market chatter is generally overwhelmingly dominated by bold predictions that things cannot continue as they have been, offset by prognosticators who take comfort in extrapolating price trends forward as the easiest path to predicting the future.  We believe that this is where we stand in emerging market debt. 

For a fixed income investor in what is still one of the highest yielding liquid fixed income asset class the bar for shunning emerging market debt (EMD) should be higher, especially in a world where developed market yields remain far too skimpy to generate reasonable amounts of income for investors needing returns well above where those yields currently reside. 

In emerging markets, extended, frothy asset markets tend to affect economic fundamentals that then leave governments vulnerable to any reversal—in short, in this asset class the seeds for ushering in a virtuous or vicious cycle are always sown in the midst of the current cycle.  But we don’t see signs of that happening and, until it does, we feel that a compelling narrative for selling does not fundamentally exist. 

One key metric to watch is real exchange rates.  When they rise precipitously, external account deficits rise and countries become ever more vulnerable to a reversal, even modest, in inflows.  Think of it as being progressively more vulnerable to a change in the weather.  When that change happens, the switch from virtuous to vicious can come in relatively short order.  The good news for current investors is we are a significant way from levels that would be worrisome. 

Real exchange rates in the asset class--as a general rule--peaked in the 2009-2011 timeframe as the commodity super-cycle, a weaker dollar, and capital inflows conspired to send exchange rates higher.  At the same time inflation ran significantly higher than developed countries, which contributed to real levels of exchange rates climbing.  All of that came tumbling down when the Fed started making noises about trimming QE in 2013.  Investors tend to forget that from mid-2013 to the end of 2015 nominal exchange rates fell on average an astounding 50%!  Local currency returns in 2015 as measured by the JP Morgan GBI-EM Global Diversified Index were the worst in history, by nearly 600 basis points.

So we worked off that period of excessive exuberance and then some, which of course laid the groundwork for early 2016 when the dollar peaked, flows returned, and markets aided central banks in relaxing policy to promote growth down the road--namely, the current cycle. 

The chart below shows that, for several key EM countries, we are far from real exchange rate levels that would be worrisome, though most have risen from the bottom.  What is different, and even more encouraging for this cycle, is that inflation in EM is historically quite low.  That should extend the period of well-priced real exchange rates.  With the possible exception of Turkey, external deficits are not nearly troublesome. 

Therefore it seems clear to us we are still lacking in fundamental reasons to cut this “winner” short.


Source: Haver, JP Morgan, Schroders. Data as of January 12, 2017. Past performance is no guarantee of future results.

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.