Fixed Income

EMD Relative weekly notes

Week Ending June 9, 2017

06/13/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

This week,

a) questions about the US president's actions that might have implied an attempt to obstruct justice,
b) a European Central Bank (ECB) meeting that had to delicately address the issue of maintaining QE while growth recovers, and
c) a UK election with an unhappy ending all occurred--and virtually nothing happened in markets (with the exception of the pound's reaction to the UK vote).

Thus the question arises: what might derail asset price tranquility?

An honest response has to be "we don't know.” What has happened in other times of induced market stress has been (by definition) unexpected, but in hindsight seems to have been obvious or somehow avoidable. Certainly emerging markets would not escape a broad bout of macro turmoil, but as in every virtuous cycle fundamentals have improved in the asset class and continue to do so. Therefore, investors expecting a specific EM-centric trigger to induce a spike in global asset price volatility may well be disappointed.

Foreign exchange reserves in emerging markets continue to rise as liquidity comes into the asset class, bolstering protection against potential volatiliity. Central banks are broadly cutting rates. The last two currencies that experienced significant volatility, Turkey and Mexico, will be the last to turn towards easing but that shift seems in sight for both. Lower rates boost growth prospects, and we still expect GDP growth to be roughly equal to that of developed markets with declining inflation. Nominal currencies fell by an average of 50% in the period prior to the market turn that started in January 2016, perhaps the largest collective fall in history, so the subsequent rebound should be presumed, we believe, to have some staying power as long as initial economic conditions remain in place.

Those conditions are a stable-to-softer US dollar, a lack of developed market central bank divergence combined with a reluctance to aggressively curb easy monetary policies, and growth in developed markets that is stable even if low. As long as these are in place, a broader macro trigger outside of those conditions seems like a necessary condition to reverse the rebound in EM currencies.

Politically, within EM we have already seen a major country in Brazil endure corruption charges against a leader with a potential to create change. Yet after an initial fall asset prices have stabilized and re-traced about half their losses in most categories. This, to us, demonstrates that with a positive global backdrop, it takes a lot to impair asset prices over short periods.

Of course, Venezuela remains an outlier. Cracks in the story become more apparent every week, and asset prices began to finally wobble a bit this week, but we remain impressed by the market's complacency. So while we don't discount the possibility that a sudden stop there would be met with surprise and speculation about spillover to the rest of the asset class, we think that there is a meaningfully less than 50% probability of this happening in a low volatility world with its current characteristics.

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.