Momentum builds, but EMD relative investors should beware the dollar

In his regular market comment, James Barrineau says the recent rally in the emerging markets debt relative market looks more soundly-based than similar strength seen in 2014, but investors still need to beware the dollar.

1 March 2016

James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

Balanced opportunites

February will almost certainly be the second consecutive month when the emerging markets (EM) local currency bond index has been ahead – the first time we have seen that since the first half of 2014.

So what happened next that year? The US Federal Reserve (Fed) started preparing the market for rate hikes, which tightened financial conditions, caused a large spike in the dollar, and a fall in the local currency EM bond index (JP Morgan GBI-EM) which has seen it drop by about 23% since then.

Assuming that a rising dollar and tightening credit conditions do not choke it off, the opportunity in emerging markets this time will be more balanced between credit risk, interest rate risk, and currency risk – with EM currencies offering the most upside, given their recent fall from grace.

Dollar risk

It remains our belief that the local currency story is dominated by the dollar, at least at present.

From the start of February to the 11th of that month, the dollar index fell by 4%, but since then it has risen by about 2.7%, driven by “Brexit” fears which have hurt both the pound and the euro.

Clearly, a resurgence of dollar strength could help derail a more positive story for EM currencies.

What does the price of oil tell us?

However, another key factor for emerging markets – the price of oil – has not been correlated with the most recent move in the dollar.

West Texas Intermediate, a key marker for oil prices, has risen by just under $4 from a near-term low on February 11.

That seems to signal that the dollar strength is probably viewed by the market as less of a structural move driven by improved fundamentals and more of a temporary spike driven by fears surrounding other currencies.

However, this must remain a tentative thesis at this point until further supporting data comes to light.

Nevertheless, higher oil prices are generally positive for the asset class and will likely encourage investors back into the market, if history is any guide.

Leaving aside speculation about possible deals to limit production amongst oil producers, these buyers are likely to be comforted by falling US rig counts and what seems like the endgame for many stressed smaller producers.

This is feeding into the heavily-backed consensus view that the oil price will now grind slowly up to $45 or $50 by the end of the year. If that materializes, we would see it as a significant plus for the asset class.

Substantial gains

Aside from the recovery in the local currency bond index, February has also seen a move into positive territory for dollar EM bonds.

Since the February 11 market low for all asset classes, investment grade sovereign spreads have compressed by 36 basis points, yet remain about 75 basis points above their historical average. So there could be substantial gains to come from here.

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