Fixed Income

EMD Relative weekly notes

Week Ending December 9, 2016

12/12/2016

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Three factors have been affecting emerging markets (EM) recently, both in general and specifically towards which parts of the opportunity set might represent value. We would identify these as: risk appetite in general, interest rates and the reflation trade, and the US dollar.

Risk appetite as judged by equity markets is certainly buoyant. The VIX index, which measures volatility for S&P 500 Index options and is a widely used measure of investor uncertainty, is at sub-13 levels, suggesting a market pleased with recent developments. All other things being equal, this should be a benign environment for emerging market risk, but other drivers are resulting in a cloudier picture.

Interest rates have continued to rise, and the 30-year US treasury yields at 3.12% has created a headwind for EMD just as it has for fixed income in general. However, because of the benign risk environment, EM spreads to treasuries have remained very well behaved, a fact that can be forgotten when looking at absolute returns. Investment grade sovereign spreads are sitting right on the rough five year average of 200 basis points. So EMD is not particularly under-performing the broad fixed income market, and its additional yield is providing at least some cushion against a steepening curve in the US.

Lastly, the US dollar continues to make the local currency portion of the EMD opportunity set less attractive. For a time, the dollar appeared set to stabilize after a sharp post-election rise (see the chart below) but the European Central Bank’s (ECB) overall dovish message has seemed to put another boost into the strong dollar. Obviously next week's Fed meeting will fill in more blanks for investors, but a further divergence in developed market central bank policies--like the one we saw from June 2014-January of 2016--does not bode well for aggressive local currency positioning.

Source: Bloomberg, DXY Dollar Index; data as of December 9, 2016. performance shown reflects past performance which is no guarantee of future returns.

If we add these factors together it still appears viable, in our view, that parts of the opportunity set in EMD have the ability to outperform both relatively and on an absolute basis. The primary spot would likely be in non-investment grade credit risk. If the market is right in its post-election pricing and US growth rises, this sector of EM should benefit from that growth and all its offshoots, including firmer commodity prices. Treasury-sensitive EM dollar bonds, both sovereigns and corporates, may also benefit fundamentally but are likely to underperform credit risk on an absolute basis. Local currency would continue to be volatile but likely underperform as local rates rise and currencies struggle against the stronger dollar.

Of course, all this assumes that the better US growth story does indeed play out. If a major setback to that story arises, even if EMD spreads remain constant, return prospects in absolute terms could be very attractive relative to the rest of global fixed income.

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.