Do global fund flows point to further recovery in EMD relative?
Markets appear to have recovered some of their poise recently. Emerging market debt (EMD) relative specialist James Barrineau, argues that a number of fundamental factors suggest this is more than just appearances.
24 February 2016
The market has been showing definite signs of recovery from its jitters at the start of the year.
Since the February 11 market lows, the S&P 500 equity index is up about 5%, while emerging market sovereign debt dollar spreads have tightened by about 41 basis points (both as of 24 February, source: Bloomberg).
When market sentiment improves like this, it is easy to point to the factors that in retrospect looked sure to be the drivers.
But one factor remains of paramount importance to us, and that is liquidity flows. When they change for the better, asset prices rise. Whether with a bit of a lead or a lag, this is a solid rule.
The chart below compares the sovereign dollar bond index with changes in aggregate foreign exchange (FX) reserves for a number of key EM countries (excluding China), which represent a good proxy for investment flows into and out of emerging market assets.
The course of these indicators over the past 12 months or so has been interesting. In 2015, after a disappointing January for asset prices, the bond market rallied until April, then began a steady sell-off which has continued until recently.
EM reserves have tracked the market changes pretty well over that period, so the recent sharp rise is striking, suggesting as it does that recent market gains are continuing to consolidate.
Certainly, the three key investment themes we have discussed at length already this year remain intact, and have probably been strengthened by recent news:
Currency stability seems to be leading to a reduction in the perceived threat of tail risks from China.
The Chinese renminbi has appreciated by about 0.6% since the interview given by Zhou Xiaochuan, the Governor of the People’s Bank of China on February 15.
It looks like Chinese policymakers have heeded warnings from investors (including ourselves) that they needed to get better at communicating with markets.
The recent sell-off in the currency is looking more or less like a repeat of last August, when an ill-fated sharp currency depreciation led to global “risk-off” for a number of weeks.
The oil price seems to be stabilising. The market quickly discounted an agreement between the Saudis and Russians to leave production unchanged, but we think it was significant for two reasons.
- If the agreement is upheld it will effectively result in a reduction of Saudi exports this summer, when the country’s domestic demand increases seasonally by about 500,000 barrels a day.
- While we remain sceptical about the chances of achieving a broader deal, the Saudi-Russian accord seems like a necessary precursor to getting Iran on board through some more complicated deal that takes into account the lifting of sanctions and the need to increase production there.
In the mean time, future supply reductions looks to be well on track, as the US rig count continues to decline rapidly and debt-financed production disappears.
Finally, major central bank monetary policy differences appear to be narrowing. US economic data still seems soft enough to keep the Federal Reserve’s (Fed) plan to continue raising interest rates at bay, given the poor market reaction to December’s move.
At the same time, the latest estimate from the Atlanta Fed predicts current quarter GDP growth of 2.6%, so a plunge into recession also seems unlikely.
We await news on the further loosening of ECB monetary policy next month but, with the Fed effectively “out of play” for now, the dollar index has continued to tread water.
Important Information: The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 31 Gresham Street, London, EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.