Fixed Income

EMD Relative weekly notes

Week Ending June 15, 2018


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

This past Wednesday the Fed indicated that two further rate hikes (in addition to June's) seemed warranted, with an upbeat outlook for the US economy. Importantly, there was no mention of the external stresses arising—EM volatility and slowing ex-US growth—indicating that those were not (yet) real considerations. On Thursday the European Central Bank (“ECB”) laid out a timetable for withdrawing quantitative easing (“QE”) and raising rates (no sooner than a year from now!) that struck the markets as dovish.

That combination, which deepened the divergence in major central bank policies which ought to lead to a stronger USD, is a bad one for EMD. Thus the current adjustment process whereby real interest rates must rise to attract capital will continue, making local currency investing in the asset class unlikely to produce positive results for any extended period until this divergence narrows. This does not require the absolute end of the Fed hiking cycle, just a reliable signal that it is nearing. When that comes, a less severe Fed outlook and a stricter ECB outlook should turn into a positive for EMD at some point.

With a widespread acknowledgement of EM market stresses, the market is moving to a point where unambiguous value should begin to open up. Historically, this first occurs in shorter duration EM dollar bonds, and then when sentiment turns and investor flows resume longer bonds contract in spread aggressively. If one takes the new Fed forecast and assumes that in mid-2019 we will see a 3% overnight rate—which represents at or very near end-cycle—coupled with modest ECB hikes, short duration EM debt with current yield of 6% and have what we consider to be very low default risk. Realizing capital gains in addition to income, though, would await a turn in developed market the divergence of major central bank policy detailed above.

While considering the fact that EM stresses are very well along in being priced in, investors should recognize that the central bank actions now affecting EM will, in our opinion, eventually affect most other, if not all, asset classes. Looking at the combined stimulus represented by ECB and Fed balance sheet buying, that stimulus has moved from positive in 2017 to flat in the first quarter of 2018 to a negative $30B in Q2 (sources: Federal Reserve Bank and ECB). From here, it rapidly accelerates to negative $70B in Q3, negative $135B in Q4, and negative $150B in Q1 of 2019.

We think asset classes so far unaffected by this large shift in stimulus are likely to face a similar re-pricing in the relatively near future. If true, EMD is simply “ahead of the pack” and poised to look attractive on a relative basis. The 500-basis point out-performance of US high yield to EMD year to date already stands as an example of that.

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.