Fixed Income

EMD Relative weekly notes

Week Ending December 1, 2017

12/08/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Emerging market debt is, we believe, both inefficient and misperceived. As we enter the last month of a second consecutive year of strong performance it is worthwhile to put those returns into context. If you blend the three main indices for sovereign and corporate dollar and local currency (as represented by the JP Morgan EMBI GD, CEMBI BD and GBI-EM GD respectively), the past two years have generated barely sub-10% returns, consecutively. Yet to us the odds of out-performing the rest of the global fixed income opportunity set next year seem high. Logically, that should be the overriding consideration rather than any forecast for future returns.

Firstly, as long as the US dollar remains stable-to-lower EM should not be significantly more affected by any negative event than any other fixed income asset class. It is a common misperception that any negative scenario an investor might imagine would result in poor relative EM performance against other asset classes under the assumption that it is automatically more volatile. Historically, only scenarios that result in a prolonged stronger dollar period draw capital from EM and lead to extended under-performance and deteriorating fundamentals.

On this score it is encouraging for future performance that the dollar index has correlated with a flattening yield curve rather than a rising two-year bond yield. The chart below shows the dollar index peaking in the near-term at the end of October and then falling through November--in conjunction with falling long bond yields. That suggests that future Fed hikes are quite likely not going to automatically result in a dollar rally. So if investors shun EMD on the basis of a Fed hiking cycle next year they are likely making a mistake, we believe.

Source: Bloomberg, DXY US Dollar Index (white, RHS) & US Generic Government 30 Year Yield (orange, LHS); data as of December 1, 2017. Past performance is not a guarantee of future results.

A second factor is that the starting point in the race for income already has EMD in the lead. The EMBI Global spread over the Barclay's Global Aggregate Index is over 300 basis points. To imagine that EMD loses this race is to imagine an asset class-specific event leading to poorer relative performance. Yet emerging market economic growth is running at a rate twice that of the developed world, foreign exchange reserves are rising, and inflation is falling or stable in nearly every country.

The local-currency EM index is up over 13%--does that mean currencies have already appreciated steeply, leaving a risky landscape? In our view, hardly. The FX (or currency) portion of the return has been a far more modest 5.24%. Five countries have posted negative FX returns and four more have had below-index returns. We would be the first to tell you a rates return above 2017's year-to-date 7.69% is unlikely since most central banks have ended or are approaching the end of easing cycles. Nevertheless, nine countries in the index still offer average current yields above 6%. Compared with the negative real interest rates on offer in developed economies that remains an attractive proposition.

The hunt for income becomes more urgent the longer developed market central banks take to set interest rates at levels remotely near those needed to generate returns required to make ends meet for pension plans, insurance companies and ordinary investors. Any correction or return to historically sustainable equity market returns will, in our view, only underscore this point. Passing over the most fertile fields for that income in the absence of specific detrimental drivers seems to make little sense in that type of world.

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.