Multi-Asset Insights: Opportunities in emerging market debt?
The latest insight from our multi-asset team explores the prospects for emerging market debt with US interest rates expected to normalise.
21 May 2015
Is there a risk of another taper tantrum?
In summer 2013, fears that the Federal Reserve (Fed) would imminently begin to taper its bond purchasing programme led to a broad sell-off in emerging markets.
Economies with large and growing twin (fiscal and current account) deficits were hardest hit due to the heightened risk of an abrupt internal adjustment if there was a reduction in liquidity.
That is, if economies are unable to borrow as much money from foreigners, consumption, investment or government spending (or all three) must adjust.
Once that adjustment becomes sufficiently large, it represents a risk to financial stability.
Although the delay to tapering has bought emerging market economies some breathing space, we expect an eventual return to this focus on fundamentals when liquidity again becomes an issue.
Figure 1 shows how emerging market economies are performing. Most emerging economies have managed to improve their position over the last year, although we have yet to see an export recovery in line with the recovery in developed markets.
However, notable exceptions are the commodity-dependent Latin American countries, where current account deterioration has led to an increased reliance on external financing flows.
Yield suppression contributing to risk environment
The broad emerging market debt universe generated positive returns in the first four months of 2015 despite pessimism carried over from last year.
Downward revisions in global growth, uncertainty surrounding Fed normalisation, and country-specific issues contributed to the negative environment in the first quarter.
However, quantitative easing in Europe, a dovish statement from the Fed in late March and over 20 central banks easing monetary policy in the first quarter allowed for a recovery in risk assets.
In particular, the low to negative levels of developed market yields have helped to encourage risk taking.
Russia outperformed the broader market, helped by the stabilisation in oil prices and the diminishing threat of additional sanctions against the country.
The cautious sentiment towards emerging markets helps keep valuations attractive, especially compared to developed markets.
However, we believe divergent conditions across emerging markets will remain the key driver of emerging market performance in the future.
What will be the impact of a Fed rate rise?
When the Fed proceeds to cautiously lift the base rate, the impact is likely to differ substantially across emerging markets.
We believe the downward adjustment in growth and the dramatic realignment in emerging market currencies will not destabilise emerging markets.
On the other hand, significant opportunities within emerging markets, especially in the local currency debt market, could be unfolding over the next one or two years.
We have been seeing some major emerging countries remain resilient, particularly those with strong external liquidity and solvency support.
However, in the near term we remain selectively positive on local currency debt given headwinds from dollar strength and currency volatility and we expect dollar-denominated assets to remain better supported.
As a result we are upgrading dollar-denominated debt to neutral as spreads (yields relative to US Treasuries) remain fairly attractive.
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.