Fixed Income

EMD Relative weekly notes

Week Ending February 24, 2017


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

The market so far this year has demonstrated that, despite the tight link historically between the US dollar (USD) and emerging market local currency returns, investors can still enjoy positive returns despite some volatility in USD--as long as there is no sustained rally in USD. 

In February, the local currency index has risen as of this writing over 2% despite the DXY US dollar index rising from 99.5 to just about 101. Total returns for the year are over 4.25%. By far the leading performers have been those countries with higher yields, with Brazil, Russia and South Africa leading the pack. Mexico and Turkey, which have lagged for months and where central banks were forced to tighten monetary policy in response to currency depreciation, are both up over 6% for February alone.

We believe this phenomenon can continue, and the key is the gap between developed and emerging markets real yields--the difference between overnight rates and current inflation. This stark difference is illustrated in the chart below.
This is significant for investors on a forward looking basis for several reasons. First, it is clear that the starting point for investing in local currency debt is much more favorable for emerging markets than developed markets. Secondly and perhaps most importantly, unless current trends shift dramatically this gap is set to be maintained or even widen in coming months.

In the developed world, inflation is rising just about everywhere. Though absolute levels remain low, policy rates remain at very low levels and no matter the central bank--whether Fed, ECB, or BOJ, nowhere does monetary policy seem poised to tighten so aggressively that real yields would rise meaningfully.

By contrast, inflation is in general declining in emerging markets. As a whole, these countries are benefiting from a sustained period of currency stability that is now working its way towards ameliorating inflation rates. Mexico and Turkey are the only notable outliers, but the strong currency performance this month, if sustained, will lead to better inflation numbers and an eventual turning point in monetary policy in coming months(it appears that markets are anticipating that scenario). Thus, real rates will remain high for an extended period even if nominal rates fall since the drop in those rates is following the drop in inflation.

The real rate differential should thus in our opinion be maintained for some time. Absent a trending, unambiguously stronger dollar, this presents a high probability for strong returns in EM local currency investing across higher yielding countries.

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.