Fixed Income

EMD Relative weekly notes

Week Ending June 16, 2017

06/16/2017

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

We think the market reaction to this week's Fed hike, as it plays out over time, has the potential to be particularly impactful for emerging markets (and, of course, markets in general). While the Fed seems bent on "normalizing" rates and reducing its balance sheet, we think the market will grow increasingly anxious about the path of rate hikes, and accordingly has priced in an additional cut at less-than-even odds. The potential impact on the US dollar makes any anxiety particularly impactful for the path of emerging markets (EM) asset prices.

Many suspect, and after this week we would agree, that the Fed sees the low level of market volatility and the high level of equity prices as offering an opportunity to continue to move in a tightening direction. Despite the market’s evidence of equanimity, actual GDP growth prospects are falling for the current quarter according to both the Atlanta and NY Fed's GDP nowcast forecasts. The Citi surprise index for US economic releases, an index that measures actual economic data versus expectations, is at its lowest level in at least four years. By many measures credit growth is falling, including both commercial and industrial loans. Lastly, the flattening yield curve is suggesting anemic growth prospects ahead.

In short, if the Fed chooses to believe that asset markets accurately reflect current conditions rather than incredibly ample liquidity, we believe the continuing parade of actual soft economic data will likely worsen with a tipping point in the market's patience soon to follow.

There is some tentative evidence that this may be the case. After visiting historic lows earlier this month, volatility may be structurally rising slowly as opposed to exhibiting sharp, periodic spikes (see chart below). think that there is a meaningfully less than 50% probability of this happening in a low volatility world with its current characteristics.

Source: Bloomberg, VIX Index, data as of June 16, 2017  

Assuming that markets become disquieted by the Fed, would emerging markets be disproportionately affected? The dollar likely holds the answer, in our opinion. The dollar rose by just over 1% following the Fed's announcement but since has re-traced about half of that move. The dollar's continued softness despite the rising interest rate differential with the rest of the developed markets has been particularly salutory for EM currencies and inflows. An additional hike and a continued promise for more, as both the BOJ and ECB tighten policy in much more measured manners, makes continued dollar softness less likely, all other things being equal. That would be a negative for EM asset prices and currencies.

On the other hand, an equity correction could drive US bond yields lower and weaken the dollar. While it’s too early to have a high conviction level either way on the dollar yet, it does not appear that the dollar's stable-to-lower path has been interrupted yet. We have a significantly higher conviction level that if we are right about the Fed's perspective, fixed income assets with relatively generous current yields are likely to be more attractive investments in coming months than equities.

 

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.